Borrowers who opt for the minimum payment rack up additional debt because the principal and interest they are not paying gets tacked onto the balance they owe the lender. That feature is known as negative amortization.
Some option ARMs allow borrowers to accumulate 10 to 25 percent more debt beyond the original balance. Option ARMs also come with periodic conversion or reset rules that adjust monthly payments to higher levels at fixed points in time. The post-conversion monthly payments can be dramatically higher — sometimes 70 to 90 percent higher — forcing borrowers to find a cheaper alternative, cough up the extra cash, or default on the loan.
Borrowers who have higher loan balances than when they closed the mortgage face especially tough choices. The squeeze gets more painful if they had minimal equity in the house to start and home values have softened since they bought. They may find themselves underwater — having mortgage debt that exceeds the resale value of their house.
Enter Wall Street's new rules for option ARMs. Although some lenders retain option ARMs in their portfolios, many pool and sell them for repackaging into Wall Street mortgage-backed bonds. (Consumers might presume that their lender supplies the money for their home loan, but the fact is, trillions of dollars raised in the global capital markets actually fund America's home purchases through mortgage-backed bonds.)
Investors look to ratings agencies to tell them how risky the bonds are, based on the default probabilities of the underlying loans. The dominant rating agency for so-called nonconforming, jumbo and "alternative" home loans is Standard & Poor's.
Think of Standard & Poor's as a kind of gatekeeper: If a lender's loans adhere to S&P's criteria, they get into the bond pool with no extra charges. But if they carry features that Standard & Poor's considers risky, they get hit with penalties known as credit enhancements.
The effect of the penalties is to make the loans costlier and less attractive for the lenders who offer them to the public. If the penalties are steep enough, lenders make fewer loans or simply follow the rating agency's rules.
On Aug. 1, Standard & Poor's blew the whistle on option ARMs. After an intensive study of recent mortgage-backed bonds, it concluded that lenders are allowing credit standards to slip too far.
Too many of the borrowers using option ARMs are paying the minimum amount each month, accumulating potentially toxic levels of debt — especially in markets in which home values could soften.
"We wanted to jump in before this got any worse," said Standard & Poor's mortgage bond director Michael Stack.
By "any worse," he meant that if credit standards continued to decline, there would be a rising probability of defaults on option ARMs — unacceptable to bond investors.
A second development potentially affecting option ARMs is under way at the federal financial regulatory agencies. A task force headed by Deputy Comptroller of the Currency Barbara Grunkemeyer is preparing new underwriting and credit-risk guidelines on option ARMs, interest-only mortgages and reduced-documentation loans offered by the nation's lenders. The new guidelines could be out by early fall, Grunkemeyer said, but there is no specific target date.
Financial regulators have "noticed that these products have taken off in the past six months," she said. The goal of the guidelines will not be to eliminate any particular loan type, she emphasized, but "to make sure banks are offering (interest-only and option ARMs) in a safe and sound manner and doing so in a way that allows consumers to understand the risks."
Bottom line: It's probably goodbye to 125 percent mortgages at 1 percent to buyers with marginal credit, insufficient incomes, minimal down payments and no clue whatsoever about the potential payment shock lurking over the near horizon. |
