Delinquencies rising for option ARM loans

Thought the mortgage meltdown was just a subprime affair? Think again.

There's another time bomb waiting to explode, experts say: risky loans made to people with good credit.

So-called pay-option adjustable-rate mortgages, or option ARMs, were the easiest and most profitable home loans for lenders and brokers to make for much of this decade. Last year, they accounted for about 9 percent of the volume of all mortgages made in the United States and were especially popular in California, Florida and Nevada -- states where home prices rose the most during the housing boom and are now falling most sharply.

An option ARM loan gives a borrower the option of paying less than the interest due, causing the loan balance to rise. If it rises too much -- say, by 10 percent or 15 percent -- the opportunity to make a low payment vanishes and the required payment skyrockets.

That scenario is becoming increasingly common. In fact, more than 75 percent of option ARM borrowers have been making only the minimum payments, analysts at Standard & Poor's Corp. said last week. As a result, the delinquency rate on option ARMs already is jumping and is likely to keep rising sharply, S&P said. Because option ARMS went only to "prime" borrowers, they aren't eligible for the interest rate freeze that is part of a White House-backed plan to stem subprime foreclosures.

One upshot could be foreclosures growing more common in affluent neighborhoods.

"Whether it's a wealthy community or a subprime community, it all comes down to how much equity the borrower has and how much home prices fall," said Joshua Rosner, a managing director at investment research firm Graham Fisher & Co.

Option ARMs were originally offered in the 1980s by California savings and loans as a way to give some financial flexibility to self-employed people and others with variable incomes. But as homes became more expensive this decade, they became increasingly desirable simply because of the ability to make extraordinarily low payments for a good period of time.

"The only reason for taking (an option ARM) was to use the minimum payment to get more house or a bigger refi than you otherwise could afford," said Guy Cecala, editor of Inside Mortgage Finance.

Joan Olsen is an example of someone who took out a mortgage she couldn't afford. A retired welfare worker, she said she didn't fully understand the loan terms when she refinanced her San Diego condominium 15 months ago with an option ARM. Olsen, 73, had a top-tier credit score of 760 but said she could afford to make only the minimum payment on her loan, which initially was $788 a month and now is $847. Her loan balance is $289,000, up from an initial $272,000. If it hits $312,000, which it could do in 20 months, she'll be required to pay more than $2,000 a month. Meantime, home prices have tumbled: One condo in Olsen's building sold recently for $251,000, so refinancing isn't a viable possibility.

"I have no one but myself to blame," Olsen said, "for signing off on something I didn't understand."

Although option ARMs went to prime borrowers, they had many characteristics that made them riskier than standard fixed-rate mortgages.

For example, a borrower could make minimum payments as though the interest rate were 1 percent or 2 percent, when in reality interest was accruing at a much higher rate, often 7.5 percent to 8 percent.

What's more, standards for making option ARMs were loosened in 2004, when Wall Street companies began buying such loans in bulk to be converted into securities backed by the loan payments, Cecala said. Because lenders didn't have to keep the loans on their books, he said, they weren't too worried about the risk of losses.

As a result, loans of 90 percent or more of the home's value became the norm, up from a once-standard 80 percent. And many of the loans were made without verifying income or assets -- an invitation for the borrower, loan officer or broker to fudge numbers, analysts say.

Despite such risks, the initial low payments on option ARMs have kept a lid on serious delinquencies -- 3.7 percent of all option ARMs, Standard & Poor's analysts said in a report last week.

At Calabasas-based Countrywide Financial Corp., which S&P said made about a quarter of all option ARMs last year, 3 percent of such loans held by the lender as investments were delinquent at least 90 days, up tenfold from 0.3 percent a year earlier.

Before standards were tightened, several mortgage brokers and former and current Countrywide employees said, it was easy to sell option ARMs to borrowers by focusing on the low minimum payment.

As the housing market boomed, borrowers figured they could always sell the home at a higher price if they got in trouble -- and brokers pocketed big rebates for selling option ARMs, said John Diamond, a Chino broker with 39 years in the business. Although a broker might earn $4,500 for selling a $300,000 fixed-rate loan, Diamond said, the commission could total $12,000 on an option ARM of the same size.

"These loans drove the whole industry from late 1999 through late 2006," Diamond said. "It was just about the only thing any broker wanted to sell."

Olsen's lender, the Homecomings Financial unit of GMAC Financial Services, said it was negotiating with her, trying to modify her loan so she'll be able to stay in the condo, though she fears her retirement will have to end.

"I think there's no way around it," she said. "I'm going to have to work at least part time."