Deferred Interest Income, Banks, and Foreclosures

[powayseller]

Banks record the unpaid interest of Option ARMs are deferred interest. This line item has been growing rapidly.

At the end of 2005, GoldenWest Financial, Downey, Washington Mutual, and First Federal Savings held 90%, 90%, 52%, and 100%, respectively, of their mortgage loans as Option ARMs. First Federal’s deferred interest was $62.5 mil in 2005, up from $5.6 mil the year before. The larger GoldenWest had $60 mil in unpaid interest in one just one quarter in 2005.The other banks have decided to not disclose the deferred interest line item. These amounts are less than 1% of the outstanding loan balance, but how much of a percentage are they of profits?

What happens to the deferred interest line item when homeowners sell at foreclosure or lose the home to the bank?

I’m also curious how the bank gets this interest money if the homeowner sells the house early or refinances. Do the points or loan fees cover the interest?

Basically, I’m wondering how the banks will be affected on the line item of the interest they are claiming as income, if that interest is never paid, a likely scenario.

No links this time, since I’m on a laptop and the rolling mouse is an obtacle I’m not willing to deal with. I got this from the LA Times and the WSJ RealEstate Journal.

[davelj]

i think you have three separate questions here (correct me if i’m wrong):

1. what percentage of these thrifts’ of total interest income is represented by deferred interest income?

obviously it differs from institution to institution, but i’d say meaningful but not enormous (yet). to give it some perspective, golden west generated $2 billion of interest income in 1Q06. consequently, $60 million (or twice that number if you like) hurts, but is not a back breaker if it disappears. nevertheless, these option ARMs are a big concern. having said that…

the biggest problem with these articles is that they are written by non-bankers and they confuse the terminology. to use golden west as a specific example, the company has almost $121 billion in loans on its balance sheet. 90% of that $121 billion is NOT comprised of option ARMs, however perhaps 90% of their origination volume in any particular recent quarter is comprised of option ARMs and/or perhaps 90% of the company’s deferred interest income comes from option ARMs.

These option ARMs could cause huge problems for thrifts, but their composition of thrift balance sheets is not stated properly in the recent articles on the subject.

2. what happens to the deferred interest income if the homeowner prepays the loan (whether through refinancing or a sale of the house)?

assuming the homeowner receives enough to pay off the entire outstanding loan balance, the thrift gets paid off in full (including the deferred interest balance) and the loan disappears. no problem for the institution.

3. what happens to the deferred interest income if the home goes into foreclosure?

assuming the home gets sold for some number below its original mortgage balance, then both that portion of the original mortgage balance as well as the deferred interest balance gets charged off – a direct hit to the thrift’s equity.

this accounting, like the gain-on-sale securitization accounting that many lenders were using several years back, will get changed after these institutions run into serious problems, which they likely will. accrual accounting is wonderful in concept (and in practice most of the time), but sometimes it gets taken a bit too far.

[powayseller]

Thanks for the perspective. GoldenWest is an exotic loan leader, and although they issued ARMs in the 1990’s, suffered no losses in their portfolio. They credit this to strict underwriting, so their option ARMs are held by credit-worthy borrowers. I wondered why they weren’t affected adversely in the 90’s, and this explains it.

This time may be different. More homeowners are overextended. Wage inflation is not keeping up with rising interest rates in this economic cycle.

[Jim Brubaker]

The thing that irritates me about this deferred interest on Option ARMS, is that the lending institution can count that as cash received on the books. When you show 60 million in profit from option ARMS, your counting your chickens before they are hatched. It looks real good to the stockholders, the only trouble being that is isn’t really REAL!

What’s the count now, three financial lenders in Las Vegas have gone belly up now?

[davelj]

Actually, the $60 million isn’t counted as “cash” on the balance sheet, it accumulates under the generic asset heading “gross loans,” because the amount of deferred interest is added back to the previous loan balance. However, it does increase the equity account on the other side of the balance sheet. It does not, however, improve operating cash flow. Also, the $60 million is not profit, but rather revenue – two very different things.

However, you’re right in that they are counting chickens before they hatch.

[Jim Brubaker]

You bring up an interesting point here. My generalizations and lack of accounting skill shows how easy it is to over simplify a situation and distort it.

I guess, its the amount of money generated from this bookkeeping procedure, that irritates me. It implies that the institution is healthier that it actually is.

I see your difference between profit and revenue, but I think that when you mention such large numbers, it just simply eludes the reader as it did me. I apologize for steering anyone astray

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