The Next Wave of Foreclosures: Option ARMs

Whoever said, Jim Cramer, that the housing market has bottomed doesn't know anything about Option ARMs.  Those loans are represented by the light yellow bars in the graph below, the ones that surge in 2010 and 2011. 

Never mind that a record 12% of all mortgages are 30 days late, or that the real unemployment rate is 16.5% and that there is a relationship between job losses and foreclosures, the Option ARM loans represent the next major obstacle to a housing recovery, and the problem with them is that they are not easily diffused with a refinance.  Sorry, President Obama.

By design, Option ARMs were created as an affordability product that would defer interest payments into the loan balance.  The phenomenon is known as negative amortization.

In other words, most owners of these products made a monthly payment that was less than the interest-only payment.  Refinancing these Option ARMs into a historically low 30-year fixed rate mortgage will actually increase the payment. 

The longer the loan was held, the larger the loan balance would be.  Now the problem is that the longer the property is held, the more the home value declines.  Rising loan balances and falling home values don't mix well.

During a rising tide in the housing market these products were risky, during a housing depression with falling home prices, they are radioactive.

Admittedly, while the volume of Option ARMs is smaller than the sub prime tsunami that we saw in 2007 and 2008, keep in mind that we didn't have 467,000 people a month losing their job in 2007 and 2008 either.