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Beware Option ARM Resets

The Second Half of the Credit Crisis is About to Begin

Written by Ian Cooper
Posted February 2, 2009 at 6:12PM

For months, we've been saying:

"It shouldn't come as a shock when mountainous Option ARM and Alt-A loans begin resetting and the second leg of the credit crisis begins.

Alt-A loans were given to borrowers with credit scores of between 620 and 700, and included the option of interest-only loans, option ARMs, and no documentation loans that required little if any documentation for loan approval. Ninety percent of those that got an

Option ARM in 2006 provided little or no documentation.

Ninety percent!

It's estimated that only 60% of Option ARM borrowers make only minimum monthly payments. Others estimate that up to 80%.

Could it be we've just entered the second half of the credit crisis?

Just as 2008 was the year of subprime woes, this one will go down as the year of Option ARM resets (or adjustable rate mortgage resets). With billions in Option ARMs resets in 2009 and 2010, this crisis is about to unleash a fury no one's prepared for.

It won't be as bad as subprime, of course. It'll be worse.

That's because lenders created these ARMs with "teaser" features to borrowers, which included making lower minimal payments for the first few years before the loan reset to a higher payment schedule. And if that weren't bad enough, there's another feature called "negative amortization," which means you're not paying back any principal.

In fact, with negative amortization loans, your loan balance increases over time. Incredulously, every time you make a payment, you owe the bank even more. These are the loans that allow consumers to buy a house they can't otherwise afford.

As for speculators, they may use negative amortization loans if they believe prices will increase at a fast pace. But with the opposite happening, they're out of luck.

And the banks will be left holding the bag.

What should concern you is that about $750 billion worth of option adjustable mortgages (option ARMs) were issued between 2004 and 2007... and will begin resetting shortly. And banks like Bank of America, JP Morgan Chase, and Wells Fargo are in for a rough ride given their exposure to option ARMs.

Worse, as of December 2008, about 28% on option ARMs were delinquent or in foreclosure, according to reports. Compare that to the 23% default rate in September 2008. And nearly 61% of option ARMs originated in 2007 "will eventually default," according to a Goldman Sachs report.

Stay tuned to Options Trading Pit for ways to profit from the second half of the credit crisis.

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