Are Option ARMs Next Shoe to Drop?

CU360
October 5, 2009 | COMMENTS

A few years ago, many consumers embraced an alternative mortgage called the “option adjustable rate mortgage,” or option ARM. This type of mortgage let consumers pay less than the interest on the loan for the first few years. These mortgages appealed to consumers who planned to sell their homes before the mortgages reset—usually within five years.

These homeowners have become part of what some economists say is a looming threat to a housing recovery: about 600,000 option ARMs scheduled to reset in the next four years, at rates many homeowners can't afford, according to The New York Times and First American CoreLogic. Consumers who chose five-year option ARMs three years ago could see their payments nearly double in two years when the mortgages reset.

Since February, default and foreclosure rates on option ARMs have passed those of subprime mortgages, according to the research firm First American CoreLogic, in part because so many subprime mortgages have already failed.

As the housing market seeks a bottom, option ARMs—which accounted for $750 billion in mortgages made from 2004 to 2007, according to the industry newsletter Inside Mortgage Finance —remain a risk, especially because many are not eligible for refinancing. About one-third are already in default, according to analysts.

Compared with subprime loans, option ARMs are fewer but tend to have larger balances. Resets on option ARMs in recent years have often doubled the payments.

“Everyone's been focused on subprime, but we're more concerned about this,” said Todd Jadlos, managing director of LPS Applied Analytics, which analyzes data for the financial industry. “By the time subprime defaults had increased 200%, in June and July of 2007, option ARMs had gone 400%. People just didn't notice because the overall numbers weren't as high.”

Option ARMs, which lenders stopped offering last year, gave borrowers four payment options: less than the interest, which increases the balance every month; only the interest; the equivalent of a 30-year, fixed-rate mortgage; and the equivalent of a 15-year fixed.

Three-quarters of borrowers take the minimum option, which usually expires after five years or when the balance reaches a cap, generally 110% to 125% of the original loan, according to the Mortgage Bankers Association. Once the cap is reached, borrowers have to pay down a higher balance at a higher rate in a shorter period of time.

“We expect 81% of the option ARMs originated in 2007 to default, with many ending in foreclosure,” says Elena Warshawsky, a residential credit analyst with Barclays Capital. The firm expects banks to lose $112 billion on option ARMs written from 2005 to 2007.

The respite for option ARMs recently is that interest rates have dropped, so loans take longer to reach their cap and do not reset to as high a rate, said Chandrajit Bhattacharya, a mortgage analyst at Credit Suisse. Loans that would have reset this spring will remain at low rates until next year, he said.

Financial institutions are using the reprieve to help some owners refinance into more conventional loans, said Michael Fratantoni, vice president of single family research for the Mortgage Bankers Association. But the loans have had extraordinarily high rates of failure even before reaching their reset dates.