Bush Plan Leaves Out
Borrowers With Option Arms

The Bush administration is pushing its plan to help subprime borrowers whose loans are due to reset to higher interest rates next year. But left out of the mix are hundreds of thousands of borrowers with good credit who could face sharp increases in their payments.

These homeowners could be the next wave of trouble for the mortgage industry. They took out what are known as option adjustable-rate mortgages, or option ARMs, which give borrowers a choice about how much to pay back each month. If they choose to make only the minimum payment on a regular basis, their loan balance can actually rise.

That is particularly a problem when home prices are falling. Borrowers who get in too far over their heads may not be able to refinance their loans or sell their houses for enough money to pay the loans back. The result, some economists say, may be another spike in foreclosures.

In a report issued last week, Merrill Lynch economists called option ARMs "ticking time bombs" that will start "ticking louder next year." Merrill estimates that losses on option ARMs could total $100 billion, on top of an estimated $400 billion in losses on subprime and other mortgages.

Option ARMs generally carry a low introductory rate -- in some cases as low as 1% -- and often have high prepayment penalties that make it expensive to refinance. With lending standards getting tighter, refinancing may be impossible in any case.

Sheila Bair, the chairman of the Federal Deposit Insurance Corp. who has been outspoken about the need for banks to modify large numbers of loans, says option ARMs don't lend themselves to the kind of streamlined modification program recently announced for subprime loans -- yet many of these borrowers also are in financial distress. "We're seeing problems now, and there are going to be more problems," Ms. Bair says.

The attorneys general of several states are also starting to focus on option ARMs. "It is a fundamentally unfair product for most borrowers," says Iowa Attorney General Tom Miller.

Option ARMs exploded in popularity during the housing boom as borrowers were attracted to the flexible terms and low teaser rates. Some $255 billion of option ARMs were originated in 2006, according to Inside Mortgage Finance, up from $145 billion two years earlier.

A small number of borrowers with option ARMs are already facing resets that require them to make payments covering interest as well as some principal. The numbers are set to rise sharply: Nearly $156 billion in option ARMs will face payment resets between 2008 and the second quarter of 2012, according to Lehman Brothers estimates, with resets peaking in 2010 and 2011. For more than $90 billion of those loans, borrowers would owe as much as their home is worth or more, according to Lehman, which assumed that home prices will fall 6% both in 2008 and 2009.

Of course, pressure on borrowers could decrease if the housing market rebounds. The Lehman analysis looked at loans packaged into securities and held in bank portfolios.

At Consumer Credit Counseling Service of San Francisco, about 25% of calls involving adjustable-rate mortgages are from borrowers with option ARMs. About half of the callers, says Erica Sandberg, a spokeswoman for the group, "went into this situation with their eyes wide open," but thought they would be able to refinance before their monthly payments became unaffordable. "The other half are claiming that they did not understand at all what they were getting into," she says.

Jirina Koy, a data operator, and her husband, Savane, who is disabled, took out an option ARM in 2005 when they refinanced the mortgage on their 1,200-square-foot home in Stockton, Calif., pulling out about $60,000 in cash. Ms. Koy says she didn't understand the terms of the loan, which carried a prepayment penalty of more than $12,000.

Refinancing is no longer an option. The balance on the Koys' loan has climbed to $357,000 from $336,000, while the value of their home has dropped to $250,000 or less. The minimum payment on the loan has also climbed, to $1,690 from $1,460.

Countrywide Financial Corp., Ms. Koy's lender, has offered to freeze the interest rate on her loan at 5.25%, down from its current 8.5%, while requiring her to make payments of principal and interest. That would boost the Koys' monthly payment by about $375. Acorn Housing Inc., a nonprofit housing counselor working with Ms. Koy, has asked Countrywide to reduce the loan balance to the original amount to make payments more manageable.

Countrywide says it won't waive the increase in the loan balance. "Based on the financial information we received from the Koys, we believe that the monthly payment would be affordable," a Countrywide spokeswoman says.

Steve Bailey, a senior managing director at Countrywide, said the lender will often modify loans or consider waiving prepayment penalties for people experiencing financial hardship, and for those who discover soon after taking out the loan that it wasn't what they expected.

Acorn Housing says it is seeing calls from borrowers with option ARMs who are from "all walks of life," says Michael Shea, the group's executive director. "What breaks our heart is to see the seniors put in these things [who are] on fixed incomes."

Clifton C. Matthews Sr., a 65-year-old semiretired architect who lives in Fort Washington, Md., was shopping in a local grocery store this year when a mortgage broker approached him about refinancing. Mr. Matthews, who says he was rushed through the closing, wound up with a $300,000 option ARM with a prepayment penalty. "I had a better loan before the refinance," Mr. Matthews says.

He says he is making his monthly payments, but those payments don't even cover the full interest owed. It's like the money "is going into a bag with a hole in it," he says. "I'm extremely nervous." He is working with the National Community Reinvestment Coalition, a nonprofit that works on fair-housing issues, to modify his loan. NCRC has asked the lender, IndyMac Bancorp Inc., to put Mr. Matthews into an interest-only loan that carries a fixed rate for the first five years.

An IndyMac spokesman says the company can't comment on individual customer situations, but adds that the company is working with Mr. Matthews. When customers call the company, "we are very willing to talk with them and work with them to come up with a satisfactory solution for all," he says.

The complaints about option ARMs have drawn the attention of government officials, who believe that borrowers may have been misled about the terms of these loans. Colorado Attorney General John Suthers this year subpoenaed 13 mortgage companies as part of an investigation of option ARM sales practices. He says he will soon sign consent decrees with a number of these firms and take civil-enforcement actions against others. "What was advertised was a lot different from the deal people actually signed up for," Mr. Suthers says.

Illinois Attorney General Lisa Madigan has subpoenaed Countrywide Financial's mortgage-lending arm as part of an investigation that started with a look into a local mortgage broker that had put many borrowers into option ARMs. Option ARMs are "a key focus" of the office's scrutiny of the mortgage industry, says Deborah Hagan, chief of the Consumer Protection Division. Countrywide says it is cooperating with the attorney general.

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