Speaking as an accountant working on his CPA, let me offer a few points relevant to the discussion:

1.) "Negative Amortization" would not be reported as earnings, because "negative amortization" is a phrase that describes a trend in a loan's balance. Banks would report the interest charged on a loan as earnings, but they've always done that! This isn't shocking. Banks report interest charged on loans as income, and payments on loans as cashflow.

2.) Yes, as interest rates rise, and the interest charged on ARMs increases, the income banks generate from that interest would rise. However, any even remotely competent analyst would have to also evaluate their allowance for doubtful accounts. (That's the amount companies build into their budget for losses like loans that will never be repaid and other bills that they expect won't get paid) The Allowance for Doubtful Accounts would be reviewed monthly, as a matter of course, and if it was viewed as insufficient, then the company would have to increase it, which is an incurred expense. In other words, as these ARMs become more risky, the company would be forced to adjust their own projections of risk, which in turn would increase expenses tied to bad debt. More income, yes, but more expenses as well. Result: Net Income shouldn't change much. (but see point #3, for why it will change some)

3.) Banks make a certain number of loans every year. As rates rise, the new loans earn more interest, but the bank makes fewer loans, so there's some equilibruim there. However, ARMs would also revalue, earning more interest, creating the same effect as if they had made one new loans for each ARM while retiring the under-performing old loans. It's this revaluing of the interest rate that probably has the bankers excited. But there's an equilibruim here as well: as rates rise, outstanding ARMs become higher risk, with a higher amount of Bad Debt expensed in anticipation of defaults. The reaction to these increased expenses will be exactly what you think it would be:

a.) truly high risk mortgages would default, and the banks would have to eat the expenses of a lost debt.

b.) moderately risky mortages would be solicited and offered the chance to refinance into a fixed-rate loan by the bank; risk-averse banks would prefer to stabilize these loans, and customers would be ready for some relief.

c.) low-risk mortgages would be refinanced by the borrower if at all possible, but kept as ARMs by the lender if at all possible.

4.) Yes, higher rates mean ARMs generate more interest, which generates more earnings for the company. Higher rates mean more risk, which means more bad debt expense for the company, but let's take the pessimistic, "Enron economics" view, and say that the bank doesn't follow accounting rules and doesn't adjust their anticipated bad debt. This is one of the benefits to having not only an income statement, but a cash-flow statement. Interest on a loan is income, but it isn't cash income; mortgage payments are cash, but unpaid interest isn't. Likewise, increased expenses in anticipation of bad debt isn't a cash expense; like depreciation, bad debt expense doesn't represent cash that the company has to pay out then & there. (the cash was already out the door when the loan was made) However, when a lender defaults on their loan, and stops making payments, that DOES affect cash.

The Cash Flow statement is looked at a lot more closely now than in the Enron days. If a company reports substantial gains in income (as would be the case here), but the weight of those gains are, in fact, not cash-based, that's a warning sign for investors. That was the big red flag for Enron: the overwhelming majority of its income was not backed by cash but by non-cash income.

I think "Non-Cash Income" would also be a great band name.

Note that there's a place for creative financing, including neg-am loans. And that place is a *rising* market. In a rising market, reasonable appreciation of real estate value can wash the negative amortization (the increase in the balance owed), and even leave you with a paper profit.

In a falling market, neg-am loans are a disaster, however. Anyone who didn't convert their neg-am loan to a fixed loan (or sell their house if it was too costly for them), when this market began to soften late last year, is an idiot. Neg-am loans are a dangerous weapon in the wrong hands. But they're not inherently bad. Only if they're used improperly (as they have been, apparently) are they a bad thing.

One of the great fears in the real-estate biz is the number of ARMs and neg-am ARMs that will come up for adjustment, or convert to an adjustable rate, in the next two years. a LOT of residential real-estate loan paper converts to an adjustable rate about 18 months from now. There is speculation that this fact alone, this misuse of creative financing, may spell catastrophe for some sectors in the market. Mainly the middle and lower range housing purchased by people who could not have qualified for it under stricter loan rules.

It seems to be a sad fact that human beings can take any useful tool and misuse it. There is a price for that. And it will be paid. One way or the other.

As has been pointed out elsewhere, if human beings were rational consumers they would never buy too much house, and if their home turned into too much house, they would sell it and re-adjust. Problem is, humans are not rational about their housing. People very often become paralyzed when they can't pay their mortgages... a foreclosure is the end-product of a disasterous lack of planning, not an inevitable event. People who get foreclosed are usually people who don't know what they're doing.

In any event, if the worst-case scenario comes to pass, and many thousands of people around the country cannot refinance their ARMs to make them affordable, there will be a nasty housing bust.

Hmm - instead of an economic depression by prices falling, we might have one the other way around. We'll just have to wait and see.