Are Option ARMs the New Subprime Category?

Payment-option mortgages, which stretched the buying power of consumers by allowing them to make minimum payments for a period of years before adjusting to a fully amortizing rate, are poised for dramatically increasing defaults, according to Fitch Ratings and other analysts.

The problem: by keeping minimum payments low for a period of time, typically five years, borrowers face not only dramatically higher monthly bills as the loans adjust but also have built up "negative amortization," meaning they owe more than they originally borrowed. Coupled with declining home prices, that left many borrowers under water on their home loans.

The potential average payment impact? Fitch says that, on average, borrowers potentially could see their monthly bill increase by $1,053 when the loans "recast." That's on top of an average existing payment of $1,672.

Roughly $29 billion of option ARMs are scheduled to recast into amortizing loans by the end of 2009. An additional $67 billion will recast in 2010. More than $200 billion of option ARM loans are currently outstanding.

While most lenders reserved the option ARM product for "prime" credit quality borrowers, the extent of the payment increase is likely to cause delinquencies to more than double after the loans recast, according to Fitch.

The deterioration in home values coupled with the lack of refinancing opportunities for many of these borrowers "represents a significant cause for concern for investors," Fitch said in a report.

Moreover, increased defaults are likely to exert more downward pressure on home prices, Fitch said. And because the product was used to stretch buying power, especially in the case of option ARMs with 40-year amortization terms, the pain may spread into upper-income neighborhoods.

"The combined impact of payment shock, negative amortization, declining home prices and restricted availability of mortgage credit may leave many option ARM borrowers unwilling to continue paying their mortgage," said Huxley Somerville, group managing director for U.S. residential MBS at Fitch, in a news release. (c) 2008 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com/ http://www.sourcemedia.com/

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