The next wave of mortgage problems: Option ARMS

I remember when I was first offered an Option ARM mortgage, and it almost seemed too good to be true, so I dug a little deeper, and discovered that I'd only end up paying $50 per more for a traditional, fully amortizing, 30-year fixed note at under 6%. Frankly, I think most brokers tended to vastly under-estimate the potential downsides of these loans to borrowers (i.e., negative amortization and a loan that re-sets when the rising loan balance gets to a certain level) because they earned more in commissions than they would from other programs. Despite the news of rising foreclosures, some analysts are warning that there will be a new wave of Option ARM re-sets around the corner. From an article in Slate:

The most common subprime loans were known as "2/28" in the industry: 30 years, including a two-year teaser rate before the interest rate rose. Now these loans have reset, and we're seeing the fallout.

But prime borrowers, too, got loans that started out with low payments; if you bought or refinanced your house in the last few years, it's not unlikely that you have one. With an "option ARM" loan you have the "option" (which most borrowers happily take) of paying less than the interest; the magic of "negative amortization." The loan grows until you hit a specified point—the exact point varies with the lender; with Countrywide, it'll come after about four and a half years—when the payment resets to close to twice where it was on Day 1.

Just two banks, Washington Mutual and Countrywide, wrote more than $300 billion worth of option ARMs in the three years from 2005 to 2007, concentrated in California. Others—IndyMac, Golden West (the creator of the option ARM, and now a part of Wachovia)—wrote many billions more. The really amazing thing is that the meltdown in California is already happening and virtually none of these loans have yet reset...

When those dominoes start falling next year, we may or may not have a subprime bailout plan, and the discussion will start about how to bail out this next tranche of borrowers. The bailout plans on the table now, such as the one put forward by Barney Frank (one of Congress' genuinely cogent financial minds), are reasonably based on the principle of bringing payments down to a point that homeowners can afford.

But where prices fall 40 percent to 60 percent, all that goes out the window. Why? Because in expensive locales like San Diego, tens of thousands of people with 100 percent loan-to-value mortgages and option ARMs are living in homes in which they have no equity and on which they owe a lot more than the house is worth...

If you're one of the "homedebtors" (a fantastic neologism coined by the anonymous blogger IrvineRenter on the Irvine Housing Blog) in this position, you might start thinking very seriously about just how attached you are to the wisteria vine snaking over the basketball hoop on your garage. That's what a lot of other California borrowers will be doing.

The luckiest of those are the ones who used option ARMs to buy a house. For them, walking away is easy: Their loans are "nonrecourse," and the lenders can't go after them for more than the value of the house. The choice is harder for those who used the loans to refinance. The quirks of real-estate law regarding refi loans make it possible (though not necessarily easy) for lenders to try to get back more money even after taking the house.

If you think, however, that should make lenders a lot happier, forget it. LoanSafe's Bedard says that even in this group, most of the option ARM borrowers he talks to—some of them living in $800,000 houses—are already considering walking away from their deeply depreciated homes as soon as the rates reset.

Bet on this: Whatever moral qualms are being urged on borrowers to keep them from walking away from their mortgages, they'll count for a lot less than the economic reality facing borrowers whose homes have fallen in value by half. Lenders had no reservations about selling borrowers loans with rising payments that would be poisonous in a rising market. Now it seems borrowers have no reservations about leaving those lenders with the risks they begged to take...

Of course, all those people stuck between rising mortgages and falling prices are free to follow Paulson's advice: Keep making payments on an outsized mortgage, and take a bullet for the greater economic good. Fortunately for them, and perhaps unfortunately for the economy, a lot of them will come to the realization that they just don't have to.