Option ARMs Bring Pain to Borrowers and Mortgage Industry

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Some mortgage industry experts estimate that as much as one-half trillion dollars' worth of adjustable rate mortgage loans (ARMs) are scheduled to reset this year, the Washington Post reports. Many will be the nontraditional Option ARMs which allow borrowers to choose to make minimum payments, less than the actual interest on the mortgage, for up to 60 months. The portion of the interest not paid in the Option ARM is added to the principal of the mortgage, and the borrower's total debt just gets bigger each month, a negative amortization. Once the loans reach a certain amount, they automatically reset at a higher rate.

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Banks are not required to say how many of the adjustable rate mortgages they underwrite are Option ARMs, but FirstAmerican LoanPerformance, an industry tracker, estimates that 12.3 percent of all mortgages written in the first five months of 2006 were Option ARMs, according to BusinessWeek. They were 40 percent of mortgages in Salinas, California, and 26 percent in Naples Florida, 51 percent in West Virginia and 26 percent in Wyoming.

Another nontraditional form of the ARM, the interest-only loan, will reset at a much higher rate after five years, but the loan principal does not increase.

Banks are permitted by generally accepted accounting principles to carry Option ARMs at the highest option of payment, as current revenue, the fully amortized amount. But James Grant of Grant's Interest Rate has called negative-amortization accounting a “fraudulent gambit,” BusinessWeek says. The Financial Accounting Standards Board (FASB), although standing by its standard, has expressed concern that the “disclosures associated with these types of loans [are] not providing enough transparency relative to their associated risks.”

While lenders claim that borrowers understand the features of these loans, and that they are restricted to borrowers with good credit histories and solid down payments, the Washington Post says, Standard & Poor's warned last year that disturbing numbers of minimum payment loans were given to borrowers with low credit scores.

H&R Block notified Wall Street in late August that its Option One Mortgage unit, which focuses on the subprime mortgage market, would have to set aside $60 million for borrowers who are behind in payments, according to the Wall Street Journal.

Countrywide Financial, which offers mortgages in all credit categories, and Impac Mortgage and Accredited Home Lenders, subprime lenders, all report that borrowers are paying off their loans more slowly.

Banks are not changing their attitudes toward the Option ARMs, BusinessWeek reports. Cindy Manzettie, chief credit officer for Fifth Third Bank in Cincinnati, said in a letter to regulators last spring, that it's not the “lender's responsibility to help the consumer determine the appropriate payment option each month. . . . Paternalistic regulations that underestimate the intelligence of the American public do not work.”

Banks are not likely to feel a lot of pain from bad loans resulting from Option ARMs. They can sell these loans to Wall Street to be repackaged for investors with other mortgages as mortgage-backed securities. Banks also sell an unknown number to hedge funds, BusinessWeek says.

While foreclosures do not yet show an alarming rate of increase in all markets, Equity Depot reported that in Atlanta the number of foreclosures had increased by 20 percent over last year. “The number of foreclosures in the Metro area continues to track steeply upward, driven largely by the increased percentage of Adjustable Rate Mortgage Defaults,” said Mark Sulimirski, Chief Product Engineer, Equity Depot.

Foreclosure filings in Massachusetts for July were up 56 percent over July 2006, The Boston Globe reports.

As the reset date approaches, Countrywide Home Loans, the largest mortgage originator in the U.S., is sending letters to borrowers who have been making only the minimum payments on their Option ARMs, warning them of a coming increase, a separate report in the Washington Post says. Countrywide provides an example of a California homeowner who has been paying less than the minimum on a 7.6 percent loan, facing a payment that is twice what he or she is currently paying.

According to the Post, Countrywide advises borrowers to:

  • Switch their payment option out of the minimum if they can and move to either a 15-year or a 30-year standard-amortization plan.
  • Switch to an interest-only option if full payments are not feasible at the moment.
  • Explore alternative refinancing options sooner rather than later.

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