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That was the question on the cover of the September 11th edition of BusinessWeek (no link). Some of the stories of the people and how they were duped by banks and mortgage brokers astounds me. We always assume that most of the people that buy bizarre (the industry prefers “exotic”) mortgage products are people that can’t afford the house they are living in. While that was the case with some of the homeowners in the article, several refinanced from traditional mortgages into these so called “option ARM” mortgages.

The way that the option ARM works is that you can pay an extremely low amount now, one that doesn’t even cover interest, and the rest of the interest gets tacked on to your mortgage. Once your loan reaches a pre-set level, your teaser rate stops and you have to pay off the balance like it was a 30 year loan.

One couple in Superior, Wisconsin refinanced out of a 30 year mortgage with an interest rate of 5.25% (!) into an option ARM that had a 1% teaser rate. This couple’s mortgage payment dropped from $1,483 to $747 during the teaser period. They claim they were never told the additional $600 would be tacked onto the balance each month (where did they think it would go?). They were told the teaser would last three years. But because they only paid the minimum, the teaser lasted less than a year and their interest rate jumped to 7.68%. Now, they have a higher mortgage balance than before, an interest rate 2.5% higher, and a prepayment penalty of $15,000 if they want to get out.

Another man was sold two option ARMs for two different houses equal to twenty-one times his annual salary! He makes $45,000 per year and is a single father. He was given two mortgages totalling $940,000. Traditionally, he would only qualify for maybe a $100,000 mortgage.

So, why do banks and mortgage brokers push these type of products onto consumers that can’t afford to pay? At least in the last example, we know he’s in bankruptcy (his attorney is quoted) but I could have easily predicted it because his mortgage payments basically constituted his entire salary. Doesn’t the bank get hurt when he goes under?

Well, no. See, the banks figured out a long time ago that they could package this loan with other good loans and sell them to investors in products called “mortgage-backed securities”. Hedge funds love these products because they can get a large return and dictate to banks some of the terms to insulate themselves from the fallout. The banks, in turn, insulate themselves by forcing some of the more onerous provisions on to unsuspecting borrowers. Plus, they get to inflate their earnings on option ARMs in two different ways.