The housing market faces the prospect of a new round of foreclosures as hundreds of thousands of risky home loans known as option adjustable-rate mortgages reset to significantly higher payments that could force borrowers to fall behind, according to a report released Tuesday by Fitch Ratings.
About 70 percent of the $189 billion in outstanding option ARMs will reset by 2011, the report said, which would be another setback to a teetering housing market still struggling to recover from the mortgage meltdown that precipitated the financial crisis.
Option ARMs make up only 1.3 percent of percent of outstanding mortgages and were used by a far smaller segment of the population than subprime mortgages, according to First American CoreLogic, so the fallout from the resets should not be as devastating. But the unraveling of the option ARMs could be felt for years.
"It does tell you there's going to be continued front-page news about high levels of foreclosures as these loans continue to struggle," said Paul Miller, an analyst at FBR Capital Markets.
Option ARMs, also called pick-a-pay loans, allow borrowers to choose how much to pay each month. Nearly all the borrowers who took out this type of loan from 2004 to 2007 chose to pay less than the interest due. Sometimes they paid as little as 1 percent interest. But the loans eventually require the borrowers to start paying the principal and full interest rate, so the payments shoot up.
"It's a ticking time bomb for some people," said Brian Bethune, an economist at IHS Global Insight, who said banks have already written off about $500 billion of these loans and other risky mortgages. Consequently, foreclosures have substantially reduced the number of outstanding option arms.
In its report, Fitch estimates that $134 billion in option ARMs will reset in the next two years. It expects monthly payments to jump 63 percent on average, or $1,053 a month, for loans adjusting this year and next, prompting a rise in defaults and foreclosures.
One surprise is that many option ARMs have gone bad even before adjusting, suggesting that some of these borrowers didn't stand a chance, said Sam Khater, a senior economist at First American CoreLogic. As of April, more than 35 percent of option ARMs were at least two months late even though they had not reset.
"These people were having trouble making the minimum payment, let alone dealing with the payment shock once the loan adjusted," Khater said.
At the root of the problem is that many who took out option ARMs were betting that home prices would rise. The loans helped people buy homes at a time when prices surged to unprecedented highs. As long as home prices kept climbing, these borrowers could refinance before their loans adjusted. But once prices tumbled, that option vanished. Now many people cannot refinance because they owe more than their homes were worth.
The most severe problems have surfaced in states with the steepest price drops. About 75 percent of option ARMs financed homes in California, Florida, Nevada and Arizona, where prices have plunged on average 48 percent from the second quarter of 2006 to the first quarter of this year, according to Fitch.
But for people struggling to make the lower payment before the loan adjusts, refinancing probably won't help, said Guy Cecala, publisher of Inside Mortgage Finance. "Just about anything they refinance into is going to give them higher payments than they have now."
The Fitch Report covers only those mortgages that were securitized, meaning packaged into securities and resold. Fitch does not analyze that mortgage financiers Fannie Mae and Freddie Mac, or lenders, hold in their portfolios.
Recognizing the troubles ahead, some of the nation's largest lenders have tried to limit losses by modifying or working with borrowers refinance the option ARMs remaining in the portfolios, Cecala said.
Among the most aggressive have been Bank of America, J.P. Morgan Chase and Wells Fargo. Each of these has recently acquired another major lender specializing in option ARMs: Countrywide, Washington Mutual and Wachovia, respectively.
As for the loans that were securitized, only 3.5 percent of the 1 million loans made in 2004 through 2007 and covered in the Fitch report have been modified.