Option-ARMs: The Next Litigation Front in the Mortgage Meltdown?

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If you are like me and you don't feel fully briefed on Option-ARM mortgages, then you will want to read the September 2006 Business Week article entitled "Nightmare Mortgages" (here) describing the pitfalls of Option-ARM loans. Among other things, the article states: "The option adjustable rate mortgage (ARM) might be the riskiest and most complicated home loan product ever created." The article also quotes one economist as saying that the option ARM is "like the neutron bomb--it's going to kill all the people but leave the houses standing." The article, written more than a year ago, reads like a prophecy of war foretold.

An Option-ARM (as explained here) is an adjustable rate mortgage on which the interest rate adjusts monthly and the payment adjusts annually, with borrowers offered options on how large a payment they will make. The options include interest-only, and a "minimum" payment that is usually less than the interest-only payment. The minimum payment option results in a growing loan balance, termed "negative amortization." Negative amortization of course means that the principal amount increases, a truly revolting development under any circumstances, but a particularly pernicious development when housing prices are falling.

In an October 24, 2007 Wall Street Journal article entitled "Countrywide’s New Scare" (here) explains how the higher commissions, lower documentation requirements, and flexible payment options encouraged Countrywide Financial Corp.’s development of this product. Deterioration on these mortgages is further undermining the results of lenders already reeling from subprime problems. Among other things, the Journal article reports that in the period 2009-2011, monthly payments on $229 billion of option ARMs will readjust (so borrowers may have to pay more).

The problems with Option-ARMs have now claimed their first lawsuit victim: Washington Mutual, along with three of its directors and officers, has been sued in purported securities class action lawsuits federal court in Manhattan. A copy of the complaint can be found here.

According to the plaintiffs’ counsel’s November 5, 2007 press release (here), the complaint alleges that:

During the Class Period, defendants issued materially false and misleading statements regarding the Company’s business and financial results. WaMu’s loan portfolio contained more than $57 billion in adjustable-rate mortgages or Option-ARM loans. The complaint further alleges that the Company failed to disclose: (i) that it had far greater exposure to anticipated losses and defaults in its home loan portfolio, particularly with Option-ARMs, than it had previously disclosed; (ii) that defendants’ Class Period statements about the Company undertaking significant preparations and implementing defensive measures to weather the increasingly difficult credit and housing markets were patently false; (iii) that defendants had engaged in a conspiracy and scheme to inflate the appraisal value of homes with the intent to artificially increase the estimated loan-to-value ratio of its Option-ARM portfolio; and (iv) that due to the Company’s improper appraisal practices, the mortgages it had issued were much riskier than represented.

The class action lawsuit follows WaMu’s October 17, 2007 announcement (here) that it was setting aside an additional $1.3 billion in the fourth quarter to cover its loan losses (primarily as a result of problems with Option-ARMs), and the New York Attorney General’s November 1, 2007 announcement (here) of a lawsuit against FirstAmerican Corporation and ePraiseIT, alleging that they had conspired with WaMu to inflate residential real estate appraisals.

Even though the lawsuit does not specifically reference subprime loans, the connection to Option-ARMs (which often went to first time home-buyers, and one of the advantages of which was the low documentation requirements) persuades me to add it to my running tally of subprime-related securities lawsuits (here). With the addition of this case, the tally now stands at 19 lawsuits, not counting the four subprime-related lawsuits pending against home construction companies.