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Betting Big on Adjustables

First Federal's reliance on mortgages that allow for reduced payments at the start raise concerns among regulators and analysts.

April 02, 2006|E. Scott Reckard | Times Staff Writer

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.

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