Option Adjustable Rate Florida Home Loans: Trouble Emerges

Subprime Florida home loans have dominated headlines this year, but now investors and consumers are growing wary of another risky type of home loan: the option adjustable-rate mortgage, or option ARM.

Defaults on subprime Florida mortgages have surged in recent months, forcing dozens of subprime lenders out of business. Meanwhile, defaults have been minimal on option ARMs, generally granted to people with credit well above the subprime level.

Even so, the prices investors pay for option ARMs have fallen about 1% so far this year, estimates Pacific Investment Management Co., or Pimco, a fund-management company in Newport Beach, Calif. Investors aren’t panicking over option ARMs, but they are signaling greater concern about how well borrowers will cope with the eventual jumps in payments that many face, says Daniel Ivascyn, a portfolio manager at Pimco.

For some borrowers, option ARMs are ticking time bombs.

The loans are tempting because they give borrowers several payment choices each month, including a minimum payment that lets them pay no principal and only part of the interest normally due. When borrowers choose that option, the loan balance expands - a phenomenon known in the mortgage trade as “negative amortization.”

After a specified period, often five years, borrowers must start repaying the principal and meeting the full interest payments. That can cause monthly payments to more than double. If the balance outstanding gets too high - the ceiling generally is 110% to 125% of the original amount borrowed - borrowers can face sharply higher payments even sooner.

Already, many Florida mortgage loan borrowers are having second thoughts. “These loans are prepaying exceedingly rapidly,” says Frederick Cannon, an analyst at Keefe, Bruyette & Woods.

It’s hard to predict how well the remaining borrowers will deal with higher payments once they kick in. Option ARMs have been available for decades. But until the past few years, they were a niche product, designed for borrowers who wanted financial flexibility but could easily handle higher payments when they came due.

At the height of the Florida housing market boom in 2004 and 2005, however, option ARMs became a mainstream loan. Lenders hailed them as an innovative way to minimize initial payments for people straining to afford their dream houses - or for homeowners to refinance, pull out some cash and still keep payments low.

In 2005 and 2006, lenders granted about $535 billion of option ARMs, accounting for 9% of the total market, according to Inside Mortgage Finance, a trade publication.

Lenders that have made lots of these loans say they have been cautious, restricting option ARMs to borrowers with relatively strong credit reports.

But those pledges and the low level of defaults so far may create a misleading sense of security: Because borrowers can make minimal payments in the early years, problems will tend to crop up later, once people are required to start paying down the principal. A recent study by UBS AG found that the peak years for option ARMs adjusting to higher rates will be in 2010 and 2011.

Much will depend on how the housing market performs over the next few years. In many parts of the country, home prices are flat or declining, and there is no sign of a quick recovery. More people may find themselves with loan balances exceeding the values of their homes, making it hard to sell their houses if they fall behind on payments and increasing the risk of a foreclosure.

In areas where home prices are falling, “the potential for a huge spike in problem option ARM loans in a few years is very real,” says Thomas Lawler, a housing economist in Vienna, Va.

Borrowers also are realizing that option ARMs can carry higher Florida mortgage rates than most other loans, which is why so many lenders pushed them. “You can get your payment down in the short term, but you pay a bitter price” in the long run, says Jack Guttentag, a former finance professor at the Wharton School of the University of Pennsylvania who operates a mortgage-advice Web site.

Many people with option ARMs would like to refinance into another type of loan but face stiff prepayment penalties, some of which make it costly to refinance or sell within the first three years. “It’s causing some real financial pressure on people,” says Linda Bertuzzi, a mortgage banker at Meridias Capital in Las Vegas.

SOURCE: The Wall Street Journal Online