Thought the mortgage meltdown was just a sub-prime affair? Think again. There’s another time bomb waiting to explode, experts say: risky loans made to people with good credit.

Believe it or not, above quote is not lifted from the pages of the Nerd’s Eye View, despite my longstanding tendency to rant to that very effect. It comes from none other than the Los Angeles Times, in a very good article on the looming foreclosure risks posed by option ARM loans.

A more traditional mortgage requires the borrower to pay a certain amount of principal (the amount owed) in addition to some interest each month. An option ARM, in contrast, allows a borrower to make a monthly payment so small that it covers no interest and only a portion of the principal. The interest and principal that the borrower did not pay is then tacked on to the balance of the loan. Eventually, when the loan balance grows larger than a specified amount, such as 115 percent of its original size, the required payment adjusts sharply upward.

These loans were very popular here in San Diego during the late-stage housing boom. The small monthly payments allowed buyers to get into nicer homes than they could have otherwise afforded, and people by and large seemed to assume that the growth to the loan balance would be more than offset by the expected perpetual rise in home prices.

Now, between the recent home price declines and the tendency for these loans to increase in size, many option ARM borrowers are probably underwater. There is no reason for them to stop paying the mortgage, though, because their minimum required payments are so low that they are paying next to nothing to stay in their homes. So there haven’t been many foreclosures involving this type of loan just yet.

But what happens if borrowers hit their loan size limits and they suddenly find themselves making huge monthly payments on loan amounts greater than their homes are worth? At that point, we could start to see a lot of people walk away, as we are already seeing among holders of subprime loans whose payments have reset upward. The difference is that option ARMs were a lot more prevalent than subprime loans among creditworthy types who live in the areas that have thus far weathered the decline comparatively well.

According to a mortgage reset chart posted at the excellent economics blog Calculated Risk, where I also came across the LA Times story, the bulk of nationwide option ARM recasts are likely to take place in 2010 and 2011. Since San Diego was early to the housing bubble, I suspect that our recasts will tend to happen earlier than the rest of the nation’s as well, perhaps by 6 to 12 months. That’s just a guess, though, and in any case, much could happen between now and then here in the United States of Bailouts. Nonetheless, all the option ARMs out there certainly pose a further risk to our local housing market.

By the way, the “tell” that opening quote wasn’t mine was the use of the phrase “time bomb waiting to explode.” The time bomb analogy is a bit melodramatic for my taste, and anyway, I tend towards images of sausage machines sputtering or chickens coming home to roost — if possible, I like all my metaphors to involve meat products.

Update: Thanks to a reader who pointed out that I got a minor detail backwards. The option ARM mortgage payments are actually applied first to the interest, and then to the principal. My correspondent does a good job of describing the process, saying, “The borrowers you’re describing are paying only a portion of the interest that is accruing each month, and none of the principal – and the portion of the accrued interest that they are not paying is what is what is being added to their principal balance each month (i.e., their negative amortization).”


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