SAN FRANCISCO - When Linda Martin refinanced the mortgages on three different houses nearly three years ago, she thought the lower monthly payments would help her save more money for retirement.
Instead, the Lakewood, Colo. skin-care specialist is sinking in financial quicksand amid a widening mortgage morass that’s pulling down home prices and threatening to drag the economy into a recession.
“I’m hanging on by a thread, not knowing whether I am going to be living in a car in six months,” said Martin.
Martin is among the hundreds of thousands of borrowers saddled with “option” adjustable rate mortgages, risky loans that dangled bargain-basement introductory payments and also let borrowers defer a portion of interest payments until later years.
Millions of other borrowers are wrestling with another type of adjustable rate mortgage, or ARM, called “interest-only.” These loans allowed borrowers to pay just enough each month to cover the interest owed on the loan, leaving the balance of the outstanding debt unchanged.
While most of the mortgage market worries so far have focused on the huge losses flowing from the subprime home loans made to people with bad credit, the option and interest-only ARMs held by more creditworthy borrowers loom as another calamity in the making.
If the worst fears about these loans materialize, the economic damage would likely extend well beyond the United States because much of the debt has been packaged into securities sold to pension funds, banks and other investors around the world who were hungry for high yields. The fallout could also further depress housing prices, leaving U.S. consumers feeling poorer and less likely to buy merchandise imported from overseas.
So far, less than 4 percent of the option and interest-only ARMs are delinquent, well below the 14 percent rate for the subprime market, where about $1.5 trillion in home loans are still outstanding, according to the most recent data from the research firm First American LoanPerformance.
But there is still reason to be alarmed because the trouble with option and interest-only ARMs still appears to be in its early stages. Many industry observers suspect the biggest problems will emerge during the next 16 months as shoddily underwritten ARMs made near the real estate market’s peak in 2005 and 2006 climb to higher interest rates.
“Those loans are begging to blow up. This is a true financial crisis,” said Christopher Thornberg, a principal with Beacon Economics.
Lenders made an estimated $581 billion in option ARM loans during 2005 and 2006 while doling out nearly $1.4 trillion in interest-only ARMs, according to LoanPerformance. A recent study estimated about $325 billion of these loans will default, leading to more than 1 million homeowners relinquishing their property to lenders. By comparison, about $212 billion in subprime loans were delinquent through May.
The initially low monthly payments on these exotic ARMs enabled more people to buy homes and enticed other borrowers to refinance their existing mortgages to free up cash for other purposes.
Now, the exotic ARMs are tormenting overextended homeowners, reckless lenders and shortsighted investors as the teaser rates rise, dramatically driving up monthly loan payments against a backdrop of declining property values.
The conditions have deteriorated so much that Angelo Mozilo, chief executive of mortgage lender Countrywide Financial Corp., recently described the current real estate slump as the worst since the Depression ended nearly 70 years ago.
Countrywide sent out another distress signal late Thursday in a regulatory filing that warned it’s being forced to hold on to more loans than it wants to keep. “We believe the current environment of rapidly changing and evolving credit markets may provide increasing challenges for the financial services sector, including Countrywide,” the Calabasas-based company said.
Washington Mutual, another major lender of option and interest-only ARMs, echoed those concerns in a similarly bleak Securities and Exchange Commission filing that warned the subprime problems are cropping up in higher-quality mortgages, too.
Option ARMs like Martin’s are especially toxic when home prices start to shrivel.
When borrowers pay the minimum monthly amount on an option-ARM, they aren’t covering the amount of interest accruing on the loan. To compensate, lenders add the amount of unpaid interest to the mortgage’s outstanding debt.
Option-ARMs also allow for a higher monthly payment to reduce the loan’s principal, but most borrowers only make the minimum installment. At some lenders, 80 to 90 percent of the option-ARM borrowers are paying the minimum amount.
So, a homeowner who originally borrowed $250,000 under an option-ARM could end up owing an additional $5,000 to $10,000 after making the minimum monthly payment for a year, depending on the terms.
The negative amortization isn’t as troubling when home prices are rising because the borrower could still be building more equity than debt.
But now that real estate prices are sliding, the additional debt created by option-ARMs raises the chances that the property will be worth less than the remaining amount owed on the loan — a perilous position known as being “upside down.” The situation only becomes more worrisome as the teaser rates on the loans adjust upward.
It’s a scary scenario because many borrowers obtained their loans with little or no down payment, meaning they only had a small amount of equity to start. Nearly 18 percent of the first mortgages originated last year went to borrowers with no equity in the property, up from 5 percent in 2002, according to an analysis by First American CoreLogic, a research firm affiliated with LoanPerformance.
Other borrowers eroded their equity with second loans known as “piggyback” mortgages or lines of credit secured by their properties.
That means many ARM borrowers unable to afford their higher loan payments after their loans reset probably won’t be able to extricate themselves by selling their homes. And refinancing into a more manageable mortgage is becoming increasingly difficult as suddenly leery lenders stop accepting applications in an effort to avoid further headaches.
“It’s a perfect storm that is going to lead to more foreclosures with severe downward pressure on home values,” said George McCarthy, a housing economist with the Ford Foundation.
When Martin refinanced the mortgages on her home and two rental properties in October 2004, she said she owed a total of $735,000. The combined debt now stands at $777,000 and is growing by more than $2,000 each month.
Martin says she would have never refinanced if a mortgage broker hadn’t misled her about how the new loans worked — a frequent complaint among borrowers with option-ARMs.
As she contacts lawmakers and attorneys in search of help, Martin isn’t focused on retirement any more. She is more worried about making sure she won’t lose her home.
“I very well may be looking at a foreclosure case,” she said. “I may just have to walk away from these loans.”