Wells Fargo Takes Chance With a Loan Exchange By Marshall Eckblad The Wall Street Journal 11-05-2009

Wells Fargo Takes Chance With a Loan Exchange
Option ARMs Are Shifted to Interest-Only in a Recovery Bet
By Marshall Eckblad
The Wall Street Journal
November 5, 2009

Wells Fargo & Co.'s strategy for modifying troubled Pick-A-Pay mortgages looks like a game of kick-the-can-down-the-road.

The fourth-largest U.S. bank by assets holds about $107 billion in debt tied to option adjustable-rate mortgages, a relic of the U.S. housing boom that allowed borrowers to make small monthly payments in return for increasing their mortgage balance. Many such borrowers now own homes worth far less than they owe in mortgage debt, and most can't afford a full monthly payment that pays down the loan's principal.

To solve that conundrum, Wells Fargo is taking a gamble: The San Francisco company is issuing thousands of interest-only loans that will defer borrowers' balances for as long as six to 10 years.

Wells Fargo is wagering that an eventual rise in housing prices in the worst-hit regions of the U.S. and a rise in consumer income, will eventually cover the bank's underwater Pick-A-Pay debt. "We're banking on the fact the economy will improve and recover over time," Michael Heid, co-president of Wells Fargo Home Mortgage, said in an interview.

The move to shift Pick-A-Pay borrowers into interest-only loans helps Wells Fargo avoid hefty write-downs on Pick-A-Pay mortgages that would likely result from foreclosures. But the strategy will leave Wells Fargo holding billions of dollars in mortgage debt tied to distressed properties in battered markets, especially California and Florida.

Mr. Heid, who runs Wells Fargo's mortgage-servicing unit, says most borrowers are motivated to pay their mortgages, even if they owe far more in mortgage debt than their houses are worth. One motivation driving borrowers is "kids and schools" having "a very strong play in why do people try and stay in their homes when they're under water," he said.

In October, Wells Fargo said it expects Pick-A-Pay loans to generate fewer losses than the bank forecast late last year. Pick-A-Pay loans accounted for 10.8% of Wells Fargo's average total loans in the third quarter.

Wells Fargo didn't issue option ARMs but inherited $119.7 billion of them when it purchased Wachovia Corp. last year. The Charlotte, N.C., bank concentrated its Pick-A-Pay-branded loans in the most overheated housing markets.

Wells Fargo has written $2 billion off Pick-A-Pay balances for borrowers, or nearly $46,000 per modified loan. The bank has modified 43,500 Pick-A-Pays so far this year through September, and said the program is effective at keeping borrowers in their homes. The program eliminates the nearer-term risk for borrowers of sharply ballooning payments, according to the company.

Danny Annan, an Orange County, Calif., engineer, said Wells Fargo recently offered to reduce his loan balance by $100,000 and transfer the remaining balance to a six-year interest-only loan with an initial interest rate of about 4.9%, Annan said. The offer will leave Annan more than $100,000 underwater on his home.

"It looks like a Band-Aid," Mr. Annan said. "It's not like we're not being appreciative," he said, adding that there is little choice but to accept the bank's proposal. Two homes on his block have been empty for more than a year after his neighbors turned in the keys and walked away, he said.

Wells Fargo's emphasis on interest-only loans is at odds with some academics, government researchers and even Federal Reserve Chairman Ben Bernanke, who have said that tying borrowers to high levels of negative home equity for years ahead will worsen distressed housing markets and discourage lenders from making new loans.

Some 2.4 million borrowers a year have been losing their homes, and option-ARM borrowers are among the most beset by the plunge in housing prices.

"Borrowers have the choice of defaulting, and that's what we're going to see," said Morris A. Davis, a former economist for the Federal Reserve Board who is now an urban land economics professor at the University of Wisconsin-Madison. "

Still, Wells Fargo risks tethering itself to what former Wall Street executive David Shulman calls "wasting assets," since borrowers facing years of negative home equity likely have little incentive to maintain or improve their homes.