WASHINGTON — Call it son of subprime. Experts warn that a new wave of mortgage foreclosures may be coming soon and could rival the default rates for subprime mortgages and slow efforts to find bottom in a prolonged national housing slump.
The mortgages in question are $230 billion of option adjustable-rate mortgages, creative lending products that flourished at the height of the housing boom. In an option ARM, a borrower can opt to pay less than his or her monthly balance due, and the difference is tacked onto the outstanding loan balance.
Many experts had expected an explosion of defaults in the springtime on these roughly 564,000 outstanding mortgages. However, interest rates dropped to historic lows, and that delayed the detonation of what many housing analysts still see as a ticking time bomb.
"They're probably going to default at a rate that makes subprime look like a walk in the park," warned Rick Sharga, senior vice president for RealtyTrac, a foreclosure research firm in Irvine, Calif.
Option ARMs have triggers that reset to a new interest rate based on either a set timeframe or when debt exceeds some cap above the loan's value. The spring drop in interest rates allowed many borrowers to escape a day of reckoning because the lower rates prevented a triggering of that cap.
That just postponed the problem, however, because most option ARMs have five-year automatic trigger dates. These loans were most prevalent in states such as California, Florida and Nevada, where home prices have sunk so far that many homeowners are underwater: They owe more than their homes are worth.
The bulk of outstanding option ARMs — a product no longer available to homebuyers — were issued between 2004 and 2007. Monthly payments on these mortgages are due to reset to a higher lending rate between 2009 and 2012.
"They're going to have a loan they cannot afford on a house that's probably way underwater and not have a lot of good options on how to avoid foreclosure proceedings," Sharga said.
While a smaller number than subprime mortgages, option ARMs grew from 3 percent of all mortgages bundled and sold to investors in 2004 to 14 percent by 2007.
They pose risks for the broader U.S. economy because they threaten to add inventory to a depressed housing market and could hasten the blistering pace of foreclosure filings — more than 1 million from March to May alone.
"We can't rebuild housing values when there's a serious risk that another set of mortgages is collapsing," said Elizabeth Warren, a Harvard University law professor who heads a government panel overseeing the spending of Wall Street bailout money.
The Mortgage Bankers Association, representing mortgage lenders, takes a more optimistic view.
"Relative to what the industry was looking at a year and a half ago . . . the recast is not going to be the problem people thought it was going to be," said Michael Fratantoni, the vice president of research for the MBA.
If the subprime crisis hit like a heart attack, the option ARM problem is more like a worsening chronic illness.
In a prescient cover story on Sept. 11, 2006, Business Week magazine labeled option ARMs "nightmare mortgages" and warned that it "might be the riskiest and most complicated home loan product ever created."
Subprime mortgages caught the nation by surprise because of their short two-year resets to higher interest rates. Option ARMs reset over a longer horizon and thus are a slowly unfolding nightmare.
"This one, everyone knows it's worsening. Everyone sees it worsening," said Sandipan Deb, a credit analyst in New York with Barclays Capital, a global investment firm.
This long lead time gives lenders and borrowers time to seek alternatives, MBA's Fratantoni said.
Analysts put the current default rate on option ARMs at 35 percent or higher.
Most were sold into a secondary market, where they were pooled with other mortgages and sold to investors as bonds or securities. The number of these loans is quantifiable, but banks aren't required to disclose how many such loans they wrote. It's unclear how many option ARMs remain on banks' books and weren't sold to investors.
Barclays Capital estimates that at least 37.5 percent of option ARMs originated in 2005 remain outstanding, as well as 63 percent of those originated in 2006 and 82 percent that originated in 2007. Deb and fellow Barclays analysts forecast a 38 percent loss rate for pools of option ARMs originated in 2006 and 48 percent losses for those issued in 2007.
Since option ARMs were most popular in states with the largest home price declines, many borrowers owe 30 percent or 40 percent more than their homes' current values.
That puts many of the Obama administration's mortgage relief programs out of reach for them, since these programs aid borrowers by lowering interest rates.
"The problem with these option ARM borrowers is they are already paying a low rate," Deb said, adding that a better solution would involve forgiving part of the loan balance, something that most lenders have been unwilling to do.
The Obama administration, however, has offered financial incentives to lenders that are willing to accept a short sale or deed-in-lieu transfers. Both of these options involve a bank taking back an underwater mortgage, freeing the owner from further payment and allowing for a speedy resale of the property, avoiding foreclosure proceedings.
"These are the kinds of properties that are right out of central casting for those types of procedures," said Sharga, of RealtyTrac.
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