"Pick a Payment" or Pick a Foreclosure

One good sign in the Option ARM issues are that analysts everywhere are aware of the future problems. The subprime and ARM issues have been very re-actionary. The huge spikes in resetting of the regular ARM were able to be taken care of through lowering interest rates. Many of these people can afford to pay their full interest with a but of principle so long as the interest rates remain low. The traditional ARMs are not increasing their debts every month - getting them further in the hole. Those who took out the Option ARMs are not so lucky. Every month they pick a lower option they are not paying any principal and are increasing the amount of interest due. Most of the loans are taking on negative amortization every month. Combined with falling home prices and Option ARMs are deeper underwater every day.

In this article from the Wall Street Journal, a look at the rising defaults from the Pick-A-Payment loans. These loans have numerous problems - they are very new and very complex. They are adjustable like regular ARMs but have negative amortization. People who qualified for a $200,000 mortgage and are paying only the minimum may not be able to payback the loan when it reaches the predetermined recasting level of 125% or $250,000. Lets take a look at the article, it summarizes many of the issues very concisely.

These mortgages, which are sometimes known as "pick-a-pay" or payment-option mortgages but are generically called option adjustable-rate mortgages, are turning out, in some cases, to be even more caustic than subprime loans, in part because the loan balance and the monthly payments on some loans is growing even as home prices are falling.

... Losses on option ARMs could be "in some cases close to subprime" mortgage levels, according to a recent report by Citigroup.

Unlike subprime loans, which went to people with weak credit, option ARMs were generally given to borrowers considered to be lower-risk. But lending standards weakened in recent years and many borrowers now have little or no equity. Many lenders reduced the teaser rates on these loans as home prices climbed, making them appealing to borrowers looking to make the lowest monthly payment possible.

Now, with home prices dropping in California, Florida and other markets where option ARMs were popular, a growing number of borrowers with these loans now owe more than their homes are worth, one reason delinquencies are climbing, lenders say.

... Most other lenders won't see large numbers of resets until at least 2009 or 2010.

Many borrowers now say they didn't understand the features of the loan. For example, borrowers who make the minimum payment on a regular basis can see their loan balance grow and their monthly payment more than double when they begin making payments of principal and full interest. This typically happens after five years, but can occur earlier if the amount owed reaches a predetermined level -- typically 110% to 125% of the original loan balance.

"My sense is that many option ARM borrowers are in a worse position than subprime borrowers," says Kevin Stein, associate director of the California Reinvestment Coaliton, which combats predatory lending. "They wind up owing more and the resets are more significant."

People were given complex loans at a time it was assumed house prices would keep increasing. I wonder how many people thought they could actually ever be at any advantage with this type of loan. People gambled that house prices would have to continually rise substantially year-over year. The real appraisal price would not only need to be above the negative amortization accumulation rate but for any resells that number plus a 6% realtor fee. Both the buyers and the lenders bought into this gamble.