A friend who used to be in the business of putting together mortgage-backed securities recently introduced me to the term, "Neutron Bomb Mortgages". He explained they’re called that because they get rid of the people, but leave the house standing.
I think the term needs to enter the common lexicon. Everybody who debates how the nation’s financial recovery program should work needs to know the term. It should be used automatically by anyone arguing for "Cramdown" provisions in mortgage law.
From the September 11, 2006 Business Week.
http://www.businessweek.com/...
Pros Go Unscathed
Why are hedge funds willing to buy risky loans directly? Because they can demand terms that help insulate them from losses. And banks, knowing what the hedge funds want in advance, simply take it out of the hides of borrowers, many of whom qualify for lower rates based on their credit histories. "Even if the loan goes bad, [the hedge funds are] still making money hand over fist," says Engel.
Eventually, some of it will go sour. But the Wall Street pros who buy option ARMs are in the business of managing risk, and no one expects widespread losses. They've taken on billons in iffy option ARMs, but the loans are no shakier than the billions in emerging market debt or derivatives they buy and sell all the time. Blowups are factored into the investing decision.
Banks that hold lots of option ARMs on their books will surely be hit by loan defaults in coming years. "It's certainly reasonable to expect to see some excesses wrung out," says Brad A. Morrice, president and CEO of New Century Financial Corp. But even here the damage will likely be limited. Banks use insurance and other financial instruments to protect their portfolios, and they hold real assets -- homes -- as collateral. Christopher L. Cagan, director of research and analytics at First American Real Estate Solutions, a researcher and unit of title insurer First American, forecasts total defaults of $300 billion across all types of loans, not just option ARMs, over the next five years -- less than 1% of total homeowner equity. (In comparison, JPMorgan Chase & Co. alone has a mortgage portfolio of $182.8 billion.) Cagan estimates that banks will end up losing only $100 billion of it all told.
From
http://www.bloomberg.com/...
``We call them neutron loans because they're like a neutron bomb,'' said Brock Davis, a broker with U.S. Express Mortgage Corp. in Las Vegas. ``Three years later the house is still there and the people are gone.''
The official name is "payment- option adjustable-rate mortgage". The borrower has options on how much he’ll pay each month -- at least for a while. The borrower can make payments that are less than the interest alone, but then the balance owed goes up, not down as in most mortgages. And that can’t go on for ever. When the balance gets to 110% or 120% of the original amount borrowed, the payment goes up. Way up. So does the interest rate, which often started at a very low ‘teaser’ rate.
``These could be called long-fuse, exploding ARMs,'' said Kathleen Keest, former assistant Iowa attorney general and now senior policy counsel at the Center for Responsible Lending in Durham, North Carolina. ``I've heard people say they are the most complicated product ever offered to consumers. They are the real liar loans.''
Remember when most states had laws against "usury"? Many states had laws limiting the interest rates lenders could charge. In about 1981, when interest rates went through the roof (the prime rate hit 21.5%) a lot of those laws became completely impractical. Lenders found ways to get around them, or got legislators to change them. (South Dakota may have had the most pliable legislature; I think that’s why many credit cards are technically issued by South Dakota banks or find some way to get under South Dakota laws.) Well, most interest rates are back down in a very reasonable range. We may need those usury laws again, but they need to cover not just interest rates but also the permissible conditions on loans.
We also need for bankruptcy courts to be able to throw out a lot of the draconian conditions on these already existing ‘neutron bomb loans’. That's been called "Cramdown" -- here's a good diary on it:
http://www.dailykos.com/...
The question shouldn’t be "Whose fault is it that this borrower took out a loan he couldn’t afford, and who should take the financial hit?" That's how Rick Santelli wants to frame it. The question should be, "Do we preserve or destroy value by putting this family out of this house?" If the house is going to sit empty and decay, it preserves value to have a family continue to live in it and take care of it. It doesn’t matter much whether we say the family is renting the house at a subsidized rate while holding an option to buy later, or buying the house on a negative - amortization loan, or something else. We need some arrangement in which both the lender and the family living in the house have an incentive to preserve its value.