Betting Big on Adjustables
For much of its 77 years in Santa Monica, First Federal Bank of California led an unremarkable existence. If outsiders took note, it was probably because First Federal’s parent company had a memorable stock symbol, FED, and for 16 years had an actress on its board -- June Lockhart, the reassuring mother on “Lassie,” television’s long-running collie saga.
Nowadays First Federal is stirring up more excitement, on account of its emphasis on making relatively risky home loans. In fact, to listen to some Wall Street skeptics you might conclude that this sleepy savings and loan has taken a figurative dive off the end of the Santa Monica Pier.
“Sell the FED,” shouted a headline in the March 10 Grant’s Interest Rate Observer, an investment publication.
In another investment newsletter, Daniel Seiver, a visiting professor of finance at San Diego State, on Feb. 28 decried First Federal’s “heavy exposure in the Southern California market, which we think is one of the bubbliest and riskiest in the nation.”
Seiver recommended short sales of stock in the parent company, FirstFed Financial Corp. He wasn’t the first to suggest this strategy, which would turn a profit if the company’s stock price fell: In fact, the volume of such short-sale bets against First Federal nearly tripled from late 2004 to early this year, before dropping slightly in March after the thrift reported solid earnings.
The short sellers question whether First Federal’s financial results are being inflated by accounting rules, which they contend may overvalue risky loans. And they are among those predicting a meltdown in California’s recently superheated housing market.
Other critics accuse First Federal and other West Coast thrifts of overindulging borrowers’ lust for artificially low initial payments. By generating so-called exotic or nontraditional mortgages, they warn, these S&Ls; have allowed speculators to buy homes they can ill afford -- and will be unable to resell when the mortgage payments rise and home prices take a tumble.
“I think this spring you will see housing prices crack,” said Richard X. Bove, a banking analyst with investment bank Punk, Ziegel & Co. That, he added, “is going to be terrible” for people with mortgages that let them pay less -- sometimes a lot less -- than the full monthly payment during the early years of the loans.
After those payments are reset to their full amounts, “I think you’re going to see a wave of defaults,” Bove said.
If such a debacle is in the offing, First Federal at first glance appears to be an unlikely place to look for culprits.
The S&L;, which has turned up on Business Ethics magazine’s corporate citizenship list, has been praised for financing affordable housing and for hiring women executives. Top managers include Babette E. Heimbuch, the chairman and chief executive, and Shannon Millard, an executive vice president who heads real estate lending.
Heimbuch, a 57-year-old accountant, joined First Federal as chief financial officer 24 years ago after auditing its books for KPMG Peat Marwick, and worked her way up to the top job. President James P. Giraldin and current CFO Douglas J. Goddard later made similar jumps from KPMG.
In a recent interview at First Federal’s modest headquarters in downtown Santa Monica, Heimbuch, Giraldin and Goddard acknowledged that their loans bent once-traditional rules. The thrift allows borrowers to defer interest payments, for example, and often waives the requirement for them to produce pay stubs or other proof of income.
Regulators, consumer advocates and skeptical investors have raised questions about the deferred-interest loans, formally known as payment-option adjustable-rate mortgages, or option ARMs for short.
Option ARM borrowers can choose to pay less than the full interest due each month, but there’s a trade-off: The difference is added to the loan balance and the full monthly payments must be made starting at a later time, often after five years. These full payments also can be triggered if the loan balance rises enough, to 110% or more of the original amount.
In an environment of rising interest rates, borrowers in certain circumstances could see their payments as much as double if this occurred.
Many lenders larger than First Federal offer option ARMs, including rival thrifts like Oakland’s Golden West Financial Corp., parent of World Savings, and Downey Financial Corp. in Newport Beach. Seattle-based Washington Mutual Inc., the largest S&L; by far, and Calabasas-based Countrywide Financial Corp., the nation’s largest mortgage lender, have helped to popularize option ARMs across the country.
But First Federal has taken to them like few others. Of all the home loans that Washington Mutual held at the end of 2005, 52% were option ARMs, the company said in its annual report to the Securities and Exchange Commission. Golden West and Downey said more than 90% of their loans were option ARMs. At First Federal, 100% of residential mortgages were option ARMs.
First Federal executives contend that they also have more experience with this kind of mortgage and that they build in more safeguards. Those include setting aside large reserves for losses and maintaining tough standards for credit scores, debt loads, down payments and other indicators of repayment probability.
Because the company’s top leaders are trained as accountants, not salespeople, “we tend to be more conservative,” Heimbuch said. “We understand that there is risk in what we do.”
Risk aside, some critics say that deferred-interest loans distort the picture of the thrift’s true performance. By a quirk of accounting rules, the deferred interest added to the loan balance is recorded as revenue, inflating financial results, the skeptics say.
Goddard, the thrift’s CFO, said that accounting for deferred interest that way was a requirement, not a choice. From First Fed’s perspective, the critics are barking up the wrong tree.
“We think those folks don’t really understand the operations of a bank,” Giraldin said. “They’re missing the important things: first, whether it’s likely the borrower is going to default on that loan, and two, whether the value of the collateral isn’t high enough if that does happen.”
Founded in 1929 by Dr. William S. Mortensen, a philanthropist who also helped start Santa Monica Hospital, First Federal became a nonprofit mutual institution a few years later during the Great Depression. Mortensen remained on the board until 1981, and one of his sons later took over as chairman of the board, retiring in 2002.
Lockhart, a longtime Santa Monica resident, provided a public face for the thrift when she joined the board in 1980, and remains on a committee that oversees First Federal’s lending in disadvantaged areas. “She is so affable, and people just love to come up and talk to her,” Heimbuch said.
First Federal ran into trouble in the early 1980s, when runaway inflation forced it to pay as much as 20% on some certificates of deposit -- far more than its loans were earning, and a formula for disaster for any lending institution.
It went public to survive, selling stock to raise capital. And like many California thrifts at the time, it switched to adjustable-rate mortgages, which are less risky for lenders because they require borrowers to pay more when market interest rates rise.
To attract customers for this then-novel product, First Federal and other adjustable-rate lenders adopted the option ARM. Variations of option ARMs have been First Federal’s bread and butter ever since. They are attractive for people whose incomes are high but irregular, and for young workers expecting sizable raises.
As home prices have spiraled higher over the last two years, all kinds of borrowers have flocked to the mortgages because they are easier to qualify for than fixed-rate loans.
Nationally, 26.4% of mortgages allowed for interest-only payments last year, up from 1.1% in 2000, according to data firm Loan Performance. In California, 35.7% of home loans provided for interest-only payments in 2005, and 23% allowed borrowers to initially pay less than the full amount of interest due.
First Federal has benefited from this trend, doubling in size from $4.8 billion in assets at the end of 2003 to $10.5 billion at the end of 2005.
“Low doc” and “no doc” loans also fueled its boom -- by the end of last year, 4 of 5 First Federal borrowers got credit without having to document their earnings, their assets or either.
Nontraditional mortgages have drawn attention from federal bank regulators, who in December proposed rules designed to rein in use of these loans at institutions that can’t demonstrate strong safeguards against their higher risks.
Industry groups have objected that the regulators’ proposals are overly restrictive, and the new rules have not been finalized. But federal examiners from agencies including the Office of Thrift Supervision, the Treasury Department division that regulates S&Ls;, aren’t waiting for them to take effect, said banking lawyer Stuart Stein, head of the financial services practice at Hogan & Hartson in Washington.
“The OTS is already walking into shops that have these loans and is essentially demanding that these institutions take action,” Stein said. “What I’m seeing from all the agencies is that they’re incredibly concerned about risk on the balance sheet, especially these low-doc and no-doc loans.”
First Federal executives declined to comment on the moves by regulators, but said they took the concerns seriously. The thrift has tightened its lending standards, including sharply raising the minimum payment from borrowers who don’t document income and assets. Heimbuch hastened to add that they haven’t tossed money around like tourists at the amusement rides on the pier. Their borrowers have an average credit score of 706, well above the “prime” borrower threshold of 620 and close to the national median score of 723.
First Federal’s mortgages average 73% of the appraised value of the home at the time they are written, a sizable cushion against loss if prices decline. Borrowers aren’t given loans unless they earn enough to repay their mortgages at the fully adjusted rate, not the low-pay option, Heimbuch said.
First Federal also is rated well capitalized by regulators, and at the end of last year had set aside $1 for every $100 of loans in its portfolio to cover future losses -- more than four times the loan-loss allowances at its closest peers, Downey and Golden West.
That caution may well prove wise: As home prices have soared, more borrowers are taking the deferred interest option. At the end of 2005, First Federal’s borrowers had deferred $62.5 million in interest payments, up from $5.6 million in just a year.
The biggest potential threat is that a major economic downturn would put large numbers of Californians out of work. Bove, the Punk Ziegel analyst, believes this is likely to occur because businesses, reacting to sky-high property prices, will move jobs to states where their workers can more easily afford homes.
Heimbuch said she has seen no indication that Southern California’s economy is slowing down.
“Right now, I can’t find 80 people I need to hire. I can’t even find recruiters to look for them,” she said. “We don’t see the risk in the job market.
“And our experience is that as long as people have jobs, they make their mortgage payments.”
