Home values are slowly rising, and interest rates are still at low tide. But some analysts see a hidden reef that could sink the housing market: option-ARM loans.
Option ARMs are adjustable-rate mortgages that give borrowers the option to make minimum payments that don’t even cover the interest owed, much less the principal. That unpaid interest gets tacked onto the principal, increasing the size of the loan.
But there’s a catch: The optional minimum-payment period usually lasts five or 10 years. Because most of the option-ARM loans were funded from 2005 to 2007, the easy-term periods have started to expire.
In a wave cresting through the coming two years, most of the estimated 900,000 borrowers who have option ARMs will lose their ability to make these teaser payments, according to First American CoreLogic, a Santa Ana real estate research firm.
“Unless option ARMs are restructured proactively, large proportions of them could end in foreclosure, leading to a potential double dip in housing prices in many California markets,” said Paul Leonard, director of the Center for Responsible Lending’s California office.
Others may be able to afford the higher payments but could choose to walk away. Median home prices in Southern California have fallen about 46% since 2007, when the last of the option-ARM loans were being written. That means many borrowers will face higher loan payments on homes worth substantially less than they were when they bought them.
Although the mortgages represent less than 2% of all home loans, they carry a total balance of nearly $300 billion -- more than half of which is owed by Californians.
For now, rock-bottom interest rates engineered by the Federal Reserve have taken some sting out of the payment increases. But that could change if, as many analysts expect, rates start going up next year.
“Insult is added to injury if the rate environment is higher,” said Mark Fleming, chief economist for First American CoreLogic. “You’re only going to have that benefit until such time as the Federal Reserve decides it’s time to tighten the screw.”
The mortgages, once geared toward affluent borrowers with irregular incomes, were expanded during the housing boom to allow people with lower credit scores, smaller down payments or other handicaps to buy homes.
That helped Coronado Fire Capt. Bill Toon, a single father.
He was delighted in 2004 when an adjustable-rate mortgage with a low-payment option enabled him to buy a house in El Cajon for himself and his daughter. The loan balance rose a bit each month, but Toon convinced himself it would eventually go back down.
Then in 2007, he learned about negative amortization, a feature in the option ARMs that tacked unpaid interest to loan principals. He saw that he owed nearly 110% of the original loan amount, and reaching that threshold would trigger a $3,000-a-month increase in his housing payment.
“I knew I was not going to be able to make the payments,” Toon said. “I didn’t read all the fine print. Shame on me, but I didn’t understand the loan.”
Option ARMs didn’t reset after two years, as did the subprime loans that exploded on many less creditworthy borrowers and precipitated a global financial crisis. The mandatory day of reckoning was five years on most option ARMs, sometimes earlier for borrowers like Toon who hit caps on how high their principal could rise.
That day has arrived and will continue hitting borrowers through 2012.
California is ground zero: About 44% of option ARMs, representing 55% of the dollar amount, were written in the Golden State, according to First American CoreLogic.
The loans, invented in the 1980s by California savings and loans, were marketed nationally during the housing boom. Now-defunct lenders such as Countrywide Financial Corp. in Calabasas and Seattle’s Washington Mutual Inc. sold most of their option ARMs and subprime mortgages to create the bonds often called toxic securities.
One of the pioneers was Golden West Financial Corp.'s World Savings Bank. The Oakland S&L was sold in 2006 to Wachovia Corp., which in turn was acquired by Wells Fargo & Co. at the end of 2008. Unlike the subprime lenders, World kept most of its loans, relying on rigorous underwriting and monitoring to limit losses.
But the deep recession caught up with the reckless and the unlucky, putting a spotlight on option ARMs and giving credence to critics who long had said consumers could not understand the mortgages’ complex features.
Kevin L. Petrasic, a banking lawyer in Washington, was a top official at the U.S. Office of Thrift Supervision in the mid-2000s when he first saw an option ARM. Petrasic said it took him an hour and a half to understand the loan a friend had used to buy a home in a pricey Washington suburb.
His analysis showed that the $1,800 initial minimum payment probably would jump to $4,800 a month after three years and could rise even higher later.
“From my point of view, it wasn’t the kind of risk you would want to take if you had a family to support,” he said.
Still, mortgage industry officials said damage from recasting rates on option ARMs has been lighter than once feared because of the low short-term interest rates and loan modifications.
The fully adjusted market rate on many option ARMs is now about 3.5%, said Barclays Capital analyst Sandipan Deb.
The low rates have helped Wells Fargo work through troubles on more than $100 billion of option ARMs it inherited from Wachovia, which had picked up most of those loans from World Savings.
Minimum payments on many Wells option ARMs are now enough to pay off some principal because actual interest rates have plunged and minimum payments have risen over the years, said Franklin Codel, chief financial officer of Wells Fargo Home Mortgage.
First Federal Bank of California, a Los Angeles option-ARM specialist shut down by regulators in December and acquired by Pasadena’s OneWest Bank, had restructured half of its home loans by late last year to cut payments. One was altered for Toon, the Coronado fire captain.
Toon said the modifications, which began after he asked the bank for help in 2007, “saved my life.” As interest rates fell, First Federal froze his payments, first for two years, then for five years and finally for 10 years, lowering the rate each time.
His rate is now 4.99% a year, and he is paying off principal as well as the interest. His payments are higher but manageable, Toon said, because he and his 16-year-old daughter have slashed spending on entertainment, clothing and other discretionary items.
“Hopefully everybody will be in a better market in 10 years” when his payments can begin rising again, Toon said. “It buys me time.”