Two More Problems with Option ARMs

The Option ARMs we referred to in the previous post were most popular in bubble markets -- California, Nevada, Florida and Arizona -- where double digit home annual price increases put the cost of buying a home out of reach. That means the markets where they'll produce the most foreclosures are among the most vulnerable in the nation.

Home prices 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 severely 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 modifications because their loan-to-value ratios will be far too high. Under the administration's Making Home Affordable program, for example, mortgages with balances that exceed +125% of the home's value are not eligible for help.

But here's the kicker: "Upwards of 80% of were stated-income loans," said Westerback. These are the so-called "liar loans" in which lenders did not verify that borrowers earned as much money as they said they did, so lenders may not be able to modify mortgages because many of the borrowers' income could not stand up to the scrutiny.

And borrowers may not want to go through underwriting again because they could be held legally liable for deliberate inaccuracies on their original applications.

Add to those conditions the still fragile economy and high unemployment rates, and you have a recipe for disaster.