Loose underwriting standards and bad assumptions about future rates of home price appreciation in the mortgage market brought nearly all credit markets to a standstill in the fall of 2007 and the spring of 2008. As bonds backed by subprime mortgages began to show default rates greater than their sophisticated structures were designed to bear, markets and financial institutions began to reprice risks of all types. The complexity of structured finance securities and off-balance sheet financing suddenly became clear.

In the spring of 2008, credit markets suffered from a liquidity crisis, and the Federal Reserve took a number of extraordinary steps to contain risk and damage to the broader economy. Additionally, the U.S. Federal Government enacted a fiscal stimulus package and various programs to help financially stressed homeowners. The media focused on the subprime mortgage problem that seems to have started the whole bursting of the credit bubble, but there is another mortgage problem that has the potential to be as big of a financial disaster as subprime lending: payment option adjustable-rate mortgages (ARMs). Read on to find out why. (For more on subprime mortgages, see The Fuel That Fed The Subprime Meltdown.)

Payment Option ARMs
Payment option ARMs (POA) are negative amortization mortgages originally designed for and marketed in the early 1980s to borrowers with irregular streams of income. A POA usually has a very low initial interest rate between 1-3.5%, which is fixed for up to three months. After this initial interest rate expires, the interest rate on the mortgage is variable according to an index plus a margin, similar to other ARM products. However, on a POA, even after the initial fixed interest rate expires, the borrower has the option to continue to make the same payment as was established by that initial low interest rate. This is known as the "minimum payment" option. If the borrower chooses to make the minimum payment, negative amortization is very likely to occur. (For more read, This ARM Has Teeth.)

Negative amortization occurs when the minimum payment is less than an interest-only payment. In other words, the size of the minimum payment is not large enough to cover even the monthly interest charge on the loan. The difference between the minimum payment and the interest-only payment is added to the principal balance of the mortgage. In other words, the principal balance of the mortgage increases each month the minimum payment option is made.

According to the terms of a POA, the borrower has the option of making the following payments.

As mentioned, POAs were originally designed for borrowers with irregular streams of income; in months in which a borrower is short on cash he or she could elect to make the minimum payment with the intent of catching up in later months. However, starting in about 2002, as home values started to increase at above historical rates of appreciation, POAs began to be heavily marketed to borrowers of all types based strictly on the appeal of making the "minimum payment." They immediately became popular in high-cost areas. Borrowers didn't seem to mind or recognize the risks of an increasing loan balance as long as their home was appreciating at 10-25% a year. Their belief was that the value of their home would continue to increase at rates well above the amount by which their loan balance was increasing. (To find additional information, see American Dream Or Mortgage Nightmare?)

Bad Assumptions, Recasts and Loan Triggers
Most borrowers who choose POAs did so based on the ability to make a minimum payment. Lenders even advertised 1% interest rates. Most borrowers didn't recognize that their interest rate starting in month two or four was actually a relatively high adjustable rate. While most borrowers recognized that the minimum payment would "recast" at the beginning of year six according to the terms of the mortgage, they assumed that even with an increasing loan balance their home would be worth enough at that point to easily refinance into a different mortgage or another POA.

When a POA "recasts" at the beginning of year six, the minimum payment is recalculated based on the fully indexed interest rate; the result is a substantial increase in the minimum payment.

In addition, all POAs have a clause called a negative amortization limit. The negative amortization limit establishes a percentage amount of the original mortgage balance to which the current mortgage balance may increase due to negative amortization before an "unscheduled recast" occurs. This limit was typically set at 110-125%. When an unscheduled recast is triggered, the minimum payment is reset based on the current fully indexed interest such that the new minimum payment is great enough to amortize the mortgage over the remaining term.

Dangers to Borrowers
Figure 1 shows interest rate, monthly payment and principal balance information on a theoretical $400,000 POA based on an initial home value of $450,000. Notice by how much the minimum payment increases at the beginning of year six. The minimum payment increases slightly each year until year six according to the terms of most POAs which call for a 7% or 7.5% annual increase in the minimum payment. Also notice the home price appreciation assumptions used to arrive at the values, and how quickly equity is lost. Finally, notice that even a drastic lowering of short-term interest rates, as estimated and shown in the chart, cannot prevent the minimum payment from increasing substantially at the start of year six. A POA borrower with negative equity in year six will find it very difficult to refinance in order to avert a substantial increase in his or her monthly mortgage payment.

Figure 1
Source: MortgageGraphics

Dangers to Mortgage Investors
Figure 2 shows the scheduled ARM resets. Notice the size of the POA market compared to the subprime market. It is substantial.

Figure 2
Source: Credit Suisse

For borrowers with negative equity in their homes who are also facing a large monthly payment increase that they cannot afford, the incentive or temptation to simply walk away from the home is substantial. The potential loss for investors is great. That potential loss increases if home prices fall. (To read more on the risk to investors, see 20 Investments: Mortgage-Backed Securities.)

Although payment option ARMs were designed for people with irregular income streams, their widespread use shows how mortgage borrowers and lenders can be lead to make poor risk-based decisions. Although these products are not a bad thing in themselves, when they are used incorrectly - particularly by borrowers who don't understand the implications of negative equity in a slowing real estate market - they can create financial problems for borrowers, and possibly lenders as well.

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