Aaron Krowne, writing at iTulip: “Pay Option ARMs are adjustable-rate mortgages what give the borrower the option of paying less than the normal monthly payment. … The difference between the “minimum” – the “fully-amortizing” amount – and the actual payment is simply added on to the principal of the mortgage. At a higher interest rate, of course. This is like making a credit card payment using the cash advance on a second credit card that charges a higher interest rate. This results in dramatically more debt overall, and a higher interest burden for the borrower overall. The added interest is called “negative amortization,” and typically there is a limit to how much of this can be added on to a loan–usually, 110% to 125% of the principal.

The way lenders or portfolio-holders of pay option mortgages account for negative amortization is surprising to the lay person: they simply take the negative amortization amount–that is, money not received–and add it to their earnings. This is called “capitalization of income from negative amortization” or “CINA.” [For] a number of mortgage lenders and bankers … a significant and increasing portion of their net income is now provided by this capitalized negative amortization:

Downey S&L … 68% of net int. income
First Fed Cal. … 72% of net int. income
Bank United … 52% of net int. income
Wash. Mutual … 17% of net int. income
Countrywide … 24% of net int. income

Countrywide’s negative amortization income jumped from $74.7 million at 12/31/05 to $654.0 million at 12/31/06—a whopping increase in excess of 8 times.

This practice of immediately marking-to-market negative amortization is actually considered valid under Generally Accepted Accounting Principles (GAAP). Of course, so were most of the tricks utilized by Enron. In fact, I would argue the neg-am situation is potentially even worse: In the case of neg-am in mortgages, what is likely to actually be a loss is marked to book as a gain. I consider this essentially a “loophole” in GAAP, which has been found by these mortgage purveyors and, in my opinion, massively abused.”