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.

Next Wave of Foreclosures Coming?

According to a new report released this week by Standard & Poors (S&P), 93% of option-ARM buyers selected the worst, most irresponsible, option.

Given a choice of which to pay: interest and principal, interest only, or a minimum amount less than the interest due; almost everyone paid the minimum -- presumably in hopes that the value would keep going up.

Nearly all of the 350,000 option-ARM borrowers owe more than when they first bought their homes thanks to the unpaid interest accumulating, and many loans written during the first big wave, which started in 2004, are getting ready for their five-year reset when they become standard amortizing loans. Some newer loans will even reset early if the accumulated interest has pushed the loan-to-value ratio above 110% to 125%.

That will change things -- in one scenario outlined in the S&P report, the payment on a $400,000 mortgage jumps from $1,287 to $2,593.

Some industry pessimists say the looming default problem could have the power to derail the nascent housing market recovery. "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.

The last year that any option-ARMs were issued was 2007. In the first 20 months after issuance, this vintage of option-ARMs had an average default rate of just over 22%.

But if you calculate only default rates for 2007 option-ARM borrowers who are now underwater, the default rate jumps to 25% after just 20 months, according to S&P.

So, regardless of how many of these kinds of loans there are out there, their high default rates will have an outsized influence on housing markets, adding to already bloated foreclosure inventories and driving prices down further.