The Problem With Option ARMs

The NYT's Christmas Day installment of its big series on the financial crisis, The Reckoning, concentrates on Herbert and Marion Sandler, mortgage lenders in California who more or less invented the toxic option ARM.

The Sandlers come across as sympathetic victims of the bubble as much as perpetrators: they clearly cared more about underwriting than most mortgage lenders, and they didn't found the Center for Responsible Lending as some kind of PR stunt.

They also believed in extending mortgages to those who had been left out of the system in its more regulated days. In principle, option ARMs are a great product for people who might earn a lot of money but who do so irregularly. That's not just bankers with big end-of-year bonuses -- the example the article gives -- but also just about anybody who's self-employed or freelance, from actors or TV producers to carpenters and, yes, many journalists.

The fundamental problem with the option ARM, I think, was one based in behavioral economics. The idea behind it is that you can get away with making small payments in lean times, and then make up for them with big payments when the large paycheck arrives. But once the product started being sold to people without a lot of financial self-discipline, those people would just make the minimum payment every month, no matter what their income. And indeed, if they had credit-card bills or other high-interest-rate debt, that would have been the sensible decision to make.

But the result was principal balances which only ever went up rather than down, especially when option ARMs started being sold to subprime borrowers -- people for whom the product was not, initially, designed.

There's another important aspect of the psychology of option ARMs: they're really hard to understand, to the point at which Tanta once spent 3,700 words trying to explain how they work. As a result, it wasn't only the borrowers who didn't comprehend what they were getting into: it was also the brokers. Senior executives such as the Sandlers did understand the product, but in a weakness common to many smart people, they probably simply assumed that their staff understood it too, rather than actually checking on that. But many of their staff, like the borrowers, probably stopped at the point where the minimum payment was calculated, since not thinking about something like this is always easier than thinking about it.

It's possible that the Sandlers were evil and predatory lenders who deliberately abused the psychology of their borrowers -- but I don't think so, especially since they kept hold of their own loans, rather than securitizing them, and that strategy, had they not sold out at the top of the market to Wachovia, was bound to blow up sooner or later. Rather, I think that the Sandlers simply let themselves get sucked into a race-to-the-bottom marketplace, especially after Wachovia put its enormous balance sheet at their disposal, and that they reassured themselves with irrelevant historical performance figures from the 1990-1 recession.

I do wonder whether a "good" option ARM can ever be devised. Maybe the trick is to force net principal repayments every year, and just leave it up to the borrower when those payments come. But it's sad that so many option ARMs turned out so badly. Because the idea behind the product is not actually a bad one, if you ignore the psychology.