Option ARMs

This tedious story has a staggering punch line.

The fuss about subprime mortgages is appropriate, but it has also been masking a bigger mortgage problem that lies a little further down the road, namely the Option Adjustable Rate Mortgage (Option ARM).

“So far the public is largely unaware Option ARMs are going to cause problems,” said Scott Stern, Chief Executive of Lenders One Mortgage Cooperative, whose 100 members originate $40 billion in mortgages annually. “But mortgage servicers know what’s looming in the pipeline.”

To the prudent person, the terms of an Option ARM sound insane. Every month you have one of three choices: pay an amount that covers the interest due plus a bit of the principal; pay only the interest due; or pay a “minimum payment” which doesn’t even cover the interest, thereby increasing the principal of the loan (sometimes called “negative amortization”).

Option ARMs also allowed people to buck the system and buy well beyond their means.

“An Option ARM fed the American aspirational mentality and allowed people to get into a home beyond what they could afford,” said Joe Dombrowski, an executive consultant at Brookfield, Wisconsin-based Fiserv Lending Solutions. “The minimum payment makes that possible.”

So, a mortgage that allows the buyer to purchase a house far more expensive than he could buy with a normal mortgage, and one that potentially puts the buyer deeper into debt each month. How prevalent are these insane arrangements?

According to the Fed, in 2005 $1 trillion in new mortgages were issued, with another $1 trillion in 2006. ARMs made up about half of the total, according to the Mortgage Bankers Association (MBA). The MBA said Option ARMs made up 7.2 percent of all home mortgages in 2005 and 14.4 percent in 2006, giving a total of around $210 billion for those two years alone.

So, roughly 11% of the buyers in 2005 and 2006 used Option ARMs, and the rate was increasing during that time. How many of those buyers were going further into debt via minimum payments?

According to a December 2006 Fitch Ratings report, almost 90 percent of people who got an Option ARM in 2006 used little or no documentation and more than 90 percent were suffering from negative amortization.

Industry insiders estimate at least 60 percent of Option ARM borrowers make only the minimum monthly payment. A Jan 22 issue of “Mortgage Strategist” a research note from investment bank UBS, estimated up to 80 percent pay the bare minimum. […]

In the meantime, as borrowers continue to make their minimum monthly payments their mortgage increases in size. But the minimum payment also rises as a result.

So, nearly all these buyers owe more than the original price of the house, most of them are digging themselves deeper into the hole each month by paying the minimum, and the minimum gets increasingly difficult to pay. Is it possible for these buyers to somehow turn things around?

Industry insiders say that as long as housing prices continue to rise and selling a house is not a problem, Option ARMs are straightforward to refinance. “Unfortunately the economic conditions are working against a lot of borrowers facing resets,” said Dale Vermillion, a mortgage industry consultant and consumer advocate.

With falling house prices, selling is difficult for Option ARM holders as they would net far less than they still owe their lender — even supposing they can sell in a slow market. As they owe far more than the house is worth and the market has been hit by a credit crunch, they also can’t refinance. Bruce Rose’s house in Boston, for instance, was valued at $325,000 in January 2006, but he owes more than $500,000.

So, here’s the punchline: aside from the turmoil caused by subprime mortgages, an additional 11% of the mortgages written in 2005 and 2006 are almost guaranteed to go into default.

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