As a string of reports continues to show a housing market in the process of seeking a bottom a couple of risks lurk on the horizon which could undo the benign real estate news coming out of the second quarter of the year. The first threat is being posed by option ARMs which accounted for $750 billion in mortgages made from 2004 to 2007, according to the industry newsletter Inside Mortgage Finance.  The option ARMs, which were often underwritten based on stated income and “no doc” applications, ceased to be offered by lenders last year. The basic premise of the loans gave borrowers four payment options: less than the interest (aka negative amortization), which increases the balance every month; just the interest; the equivalent of a 30-year fixed-rate mortgage; and the equivalent of a 15-year fixed.
With about one third of them are already in default, First American CoreLogic anticipates 600,000 option ARMS will reset within four years. A reset occurs when a homeowner’s low “teaser rate” expires, requiring a new monthly payment that can be far higher and unaffordable. These types of mortgages were usually taken out based the “given” that rising housing values would enable a refi or a sale which would preclude the homeowner from ever seeing a reset.
Since February, default and foreclosure rates on option ARMs have passed those of subprime mortgages in part because so many subprime mortgages have already failed. Compared with subprime loans, option ARMs are fewer but tend to have larger balances. Because of dynamics specific to option ARMs, resets 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 percent, in June and July of 2007, option ARMs had gone up 400 percent. People just didn’t notice because the overall numbers weren’t as high.”
The steep increases in payments aren’t exclusive to option ARMs but the conditions, often detailed in the small print of the mortgage contract and unknown to borrowers at the time of origination, set the mortgages up with triggers that could double a mortgage payment from one month to the next. One of those triggers was pointed at borrowers who elected for negative amortization payments, which were usually set with expirations of five years. At that time, the borrower would have to begin amortizing the balance on the loan which, depending on how large the balance had grown during the term of minimum payments, could double or triple the monthly payment. According to the Mortgage Bankers Association, three quarters of borrowers took the minimum option on loans originated between 2004 and 2007.
The second condition for increased payments in these loans, and likely a bigger surprise to borrowers, is triggered when the balance reaches a cap, generally 110 to 125 percent of the original balance on the mortgage. Once the cap is reached, borrowers have to pay down a higher balance at a higher rate in a shorter period of time. “This was a loan meant for sophisticated investors, or people who expected their cash flow to increase over time,” said Elena Warshawsky, a residential credit analyst with Barclays Capital, which expects four out of five  of the option ARMs originated in 2007 to default, with many ending in foreclosure. “But then they were extended to all sorts of buyers. Now it wasn’t people hoping their income would grow. It was people hoping their house price would increase” so they could refinance or sell, Ms. Warshawsky added. Barclays Capital has estimates showing that banks will lose $112 billion on option ARMs written from 2005 to 2007.
The problems currently seen in the option ARMs could be much worse but borrowers have caught a bit of a break as interest rates have dropped and remain at low levels. The lower rates result in loans that take longer to reach their cap and do not recast to as high a rate, said Chandrajit Bhattacharya, a mortgage analyst at Credit Suisse. Loans that could have recast this spring at much higher rates will remain at low rates until next year, Mr. Bhattacharya said.
Even with that respite, the option ARM loans have had extraordinarily high rates of failure even before reaching their reset dates because the allowance for stated income and no doc underwriting enabled hundreds of thousands of borrowers to buy homes that were beyond their means. Absent the options of refinancing or selling the property, delinquency, default, and foreclosure were also close at hand.
The second mortgage category which has industry watchers sweating is the Alt-A group, carrying an estimated value of $2.4 trillion.  An Alt-A mortgage, short for Alternative A-paper, is typically characterized by borrowers with less than full documentation (stated income), lower credit scores, and higher loan-to-values. The category falls between prime and subprime in terms of perceived risk. Many of the Alt-A’s were written, using minimal documentation, to allow borrowers to stretch their purchases to properties that they could not get approved for using a traditional approach.
Unlike the subprimes, which have seen the bulk of their resets, the Alt-A’s are just getting started with the peak not expected until late 2012. Approximately 65% larger than the subprime market and typically used for more expensive homes, the resets in the category could result in high foreclosure ratios due to the larger monthly payments. Higher resets in terms of actual dollars especially combined with a rising unemployment rate and tightened liquidity could pose a huge problem over the next twenty four months.
Like the option ARM’s, Alt-As are catching a break from the currently low interest rates. Lenders and servicers are using the reprieve to try get ahead of the curve, helping some owners modify into more conventional loans, said Michael Fratantoni, vice president of single family research for the Mortgage Bankers Association. If you have a looming reset which will push your payments out of reach, the time to act is now. The Feldman Law Center has negotiated hundreds of successful loan modification for their clients, saving many of them from foreclosure. Call them today at (800) 527 8497.