Option ARMs

A detonation of foreclosures will result from option ARMs set to reset to higher payments.

These unusual mortgages permitted homebuyers to come to closing with diminutive money and prefer, monthly, how much to pay: interest and principal, interest only, or a minimum amount less than the interest due.

Of course, the last alternative is the one 93% of option-ARM buyers selected, according to a new report released this week by Standard & Poors.

But ultimately, everybody has to pay the piper.

Almost all 350,000 option-ARM borrowers are indebted more than when they initial bought their homes thanks to the unpaid interest amass. And most of the loans written during the first big wave, which started in 2004, are getting ready for their five-year reset, when they become typical amortizing loans. Moreover, some newer loans will reset early if the collected interest has pushed the loan-to-value ratio above 110% to 125%.

That means borrowers have to start paying very huge prices for their homes. In one situation delineated in the S&P report, the payment on a $400,000 mortgage rises from $1,287 to $2,593.

25% default rate

But that doesn’t just spell bad news for borrowers. A few industry cynics say the threatening non-payment problem could have the power to damage the hopeful housing market revival. “The crux of the matter is that as soon as these mortgages recast, the history is that they will default,” said Brian Grow, one of the S&P report’s coauthors.

And the newer the loans, the worse they will perform, the report said. The last year that any option-ARMs were issued was 2007. In the first 20 months after issuance, this era of option-ARMs had an average default rate of just over 22%.

That includes all option-ARMs issued in 2007. But if you compute default rates for only 2007 option-ARM borrowers who are now submerged, the default rate jumps to 25% after just 20 months, according to S&P.

So, while there may not be lot of these terrible loans out there, their high default rates will have a great effect on housing markets, adding to already engorged foreclosure inventories and prices are driving down further.

Fizz markets

And the markets where they’ll produce the most foreclosures are still among the most vulnerable in the nation.

Option ARMs were most popular in fizz markets — California, Nevada, Florida and Arizona — where double digit home annual price amplify put the cost of buying a home out of reach.

Actually, 60% of these loans went to residents of California and other Western states, places where prices have drop the most, according to report coauthor Diane Westermarck. “The geography is depressing for these products,” she said.

Many borrowers in these places could only pay for a home if they chose the option ARM. Many counted on continued hot market conditions to add value to their homes. The extra equity could then be tapped to pay their bills.

We all know how that worked out.

Home value in many of the markets where option ARMs are most concentrated have fallen 30%, 40% or more. When the loans recast, most borrowers will find themselves harshly underwater.

“Because borrowers of [options ARMs] are in a much worse position,” said Westerback. “You’ll see defaults rising very rapidly.”

And most option ARM borrowers will not be good candidates for refinancing or mortgage adjustment because their loan-to-value ratios will be distant too high. Under the administration’s Making Home Affordable program, for example, mortgages with balances that go beyond 125% of the home’s value are not suitable for help.

Not so white lies

There is one more modest problem that many option-ARM borrowers seeking refinancing would face: “Upwards of 80% of were stated-income loans,” said Westerback.

These are the so-called “liar loans” in which lenders did not substantiate that borrowers make as much money as they said they did. Lenders may be unable to modify mortgages because many of the borrowers’ profits could not stand up to the examination. Borrowers may also not want to go through back again because they could be held officially liable for intentional inaccuracies on their original applications.

Add to those conditions the still flimsy economy and high unemployment rates, and you have a formula for calamity.