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The Economy's Worst Nightmare

Written By Brian Hicks

Posted June 10, 2008

For weeks, 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!

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

Say a borrower makes minimum payments on a $600,000 loan. That loan could easily be a $750,000 loan within two years.

And we’re supposed to be shocked when this problem ends in the second credit crisis?”

And we’re not alone in our thinking… Business Week just released this article on it.

“With the subprime mortgage crisis already crippling the U.S. economy, some experts are warning that the next wave of foreclosures will begin accelerating in April, 2009. What that means is that hundreds of thousands of borrowers who took out so-called option adjustable-rate mortgages (ARMs) will begin to see their monthly payments skyrocket as they reset. About a million borrowers have option ARMs, but only a fraction have already fallen due.

That was the catch to option ARMs; borrowers were offered low initial payments that would recast higher after several years. Many home buyers thought they could resell their homes before their payments increased. But instead, many of them got trapped. According to Credit Suisse, monthly option recasts are expected to accelerate starting in April, 2009, from $5 billion to a peak of about $10 billion in January, 2010. Some of these loans have already started to recast. About 13% of option ARMs that were issued in 2006 were delinquent by 60 days by the time they were 18 months old, Credit Suisse said.

California: Problem’s Bellwether

Among the states expected to be worst-hit is already battered California. Today, outstanding option ARM loans in the U.S. total about $500 billion, about 60% of which were sold to California homeowners, according to Credit Suisse. Option ARMs were especially popular in the state, where they were heavily marketed during the boom by such companies as Countrywide Financial in Calabasas, Calif.; Washington Mutual in Seattle; and Wachovia in Charlotte, N.C. Moreover, on top of their ARMs, many homeowners also refinanced their homes, driving themselves even deeper into a debt they thought they could escape by flipping their homes.

But California won’t be alone. Homeowners are also frighteningly vulnerable in states such as Arizona, Florida, New Jersey, and others.

The Mortgage Bankers Assn. said on June 5 that the option ARM problem is growing. The group reported that the national rate of foreclosure starts for prime ARMs, including option ARMs, increased to 1.55% in the first quarter, up from 0.53% a year earlier. In California the foreclosure start rate in the first quarter was 2%, vs. 0.5% a year earlier. In Florida, the rate was 2.57%, compared with 0.5% in the first quarter of 2007. “California, Florida, Arizona and Nevada combined…represent 62% of all foreclosures started on prime ARM loans, and 84% of the increase in prime ARM foreclosures,” the group said.

The option ARM loan defaults could accelerate next year even if subprime defaults subside, said Chandrajit Bhattacharya, vice-president and mortgage strategist at Credit Suisse Securities. He said California will see the bulk of the option ARM foreclosures and the rest will be spread out across the country.

Underwater and Gasping for Air

“Most of the public is thinking that the subprime thing is over, but this is another thing waiting,” Bhattacharya said. “The problem for these borrowers is that once you go underwater, it’s very hard to refinance, and if you cannot refinance there is very little option for you.”

But it gets worse.

Option ARMs, which were originally designed for self-employed people with fluctuating incomes, gained popularity with other workers during the peak of the real estate boom in 2004, when rapidly rising home values would have otherwise kept many buyers out of the market.

The loans, which were generally given to borrowers with better-than-subprime credit, give homeowners the option of making a minimum monthly payment, which covers none of the principal and only a portion of the interest, the rest of which is added to the loan balance. With years of unpaid interest accumulating and house prices falling, some homeowners have seen their equity disappear and now owe even more than their initial loan balance.

The loans automatically recast after five years, but many will recast sooner as loan balances hit specific principal caps-typically between 110% and 125% of the initial loan amount. Many of these loans are expected to recast within the next two years, meaning that borrowers’ monthly payments will swell to include both principal and interest.”

Not only does this negatively impact consumers, it’ll continue to wreak havoc on banks.