Option ARMs, next chapter in U.S. housing crisis
By Nick Carey
CHICAGO (Reuters) - The U.S. housing crisis has focused attention on adjustable rate mortgages (ARMs) and the danger posed by their spiking interest rates.
But mortgage bankers, industry experts and nonprofit officials say that the impact of one particularly nasty kind of ARM -- called the Option ARM -- involving hundreds of billions of dollars of loans has yet to be felt. And, they say, it will hit prime borrowers and subprime borrowers alike.
People like Bruce Rose, 53, who never should have got a loan.
Rose, 53, bought his home in Boston in 1986. After stress and depression forced him to retire as a state employee in April 2006 he "maxed out" his credit cards on his annual income of around $16,000.
On medication, he refinanced his debts through the largest U.S. mortgage lender, Countrywide Financial Corp. The new loan totaled $439,000. Rose said he did not know his mortgage broker and Countrywide used a stated income loan -- also called a "liar loan" because no proof of income is required -- and that they claimed his monthly income was $12,166.
"If I had known what I was signing I would never have agreed to the loan," he said. "Now I may lose my home."
With an Option ARM, borrowers can make a minimum monthly payment like a credit card, but if they do the principal increases. Rose's minimum payment rose from $1,200 a month to $2,800 and his loan now totals more than $500,000. He is fighting foreclosure.
"No reasonable lender would have given him a loan like that," said Virginia Pratt, a foreclosure prevention counselor at ESAC, a Boston nonprofit group, who is seeking legal counsel for Rose.
Countrywide -- set to be bought by Bank of America and seen by critics as a poster child for excesses leading to the housing crisis -- did not respond to a request for comment.
Rose's is an extreme case, but industry insiders say Option ARMs, also called Payment Option ARMs, will be the next chapter in the U.S. housing crisis and could push hundreds of thousands more subprime and prime borrowers into foreclosure.
"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."
Subprime borrowers have weak credit histories, while prime borrowers have good credit. Industry insiders say a skewed system that paid mortgage brokers more to sell Option ARMs than traditional loans has left even prime borrowers struggling with monthly payments and unable to either sell or refinance.
"So far we have only seen the tip of the iceberg of this problem," said Michael Lefevre, CEO of trade group the National Association of Mortgage Professionals (NAMP).
Option ARMs have existed since the 1980s, but according to a U.S. Federal Deposit Insurance Corporation report, "Outlook Summer 2006," as recently as 2002 they were still quite rare.
Like a normal ARM, the interest rate on one of these loans resets periodically. But the payment option allows you to make a minimum monthly payment instead of the full interest-only payment. The trouble is that the portion you don't pay is added to the principal of the loan, so your mortgage goes up. This process is called negative amortization.
"This product is suitable for people with a lot of money who are financially astute," said David Zugheri, president of First Houston Mortgage, which offers loans in 18 U.S. states. "But very few people fit that category and that's why we didn't make many of these loans."
Unfortunately, many other lenders did.
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.
"This product has been used by far more borrowers than it was ever intended for," said Brian Chappelle, a partner at mortgage consulting firm Potomac Partners LLC.
U.S. regulators tightened standards on Option ARMs in late 2006 and the number of new loans tailed off.
Until then, many mortgage brokers liked Option ARMs as they netted a far higher commission than a safer, fixed-rate loan.
"If you're a broker and you can get $4,000 commission for a traditional loan and $12,000 commission for an Option ARM, which one are you going to pick?" said NAMP's Lefevre.
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."
The problem is paying for it. 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.
"If you continue to make the minimum payments, a $600,000 loan can become a $750,000 loan within a couple of years," Fiserv's Dombrowski said. "You may have good credit, but now you're in a trap."
"And because you have good credit and are making your minimum monthly payments," he added, "you're not on anyone's radar screen yet."
STUCK IN A TRAP
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.
"Falling house prices and negative amortization make the proverbial perfect storm," said Potomac Partners' Chappelle.
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.
"If people keep adding to the principal on their loan, eventually it becomes the bank's problem," First Houston Mortgage's Zugheri said.
For those borrowers who could never afford a conventional fixed-rate mortgage for their properties, most will probably end up losing their homes through foreclosure.
Others could afford their mortgages if a deal were struck with their lender for a fixed-rate mortgage with no spike in payments that comes with an Option ARM.
But that would leave investors who bought Option ARM-related bonds at a premium short on cash. Lenders One's Stern said that to avert a disaster with Option ARMs, U.S. Congress needs to broker a solution that "meets the needs of borrower, the needs of bond holders and preserves the sanctity of the housing market."
That may be too late for borrowers like Bruce Rose.
"Everything my lender told me was a lie," he said. "Surely that's illegal?"
(Reporting by Nick Carey; Editing by Eddie Evans)