Getting Knocked Down by Prime ARMs

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Two aggressive Federal Reserve rate cuts in January are good news for borrowers with ARMs, especially those with resets coming this year. Although ARMs are not directly tied to the federal funds rate, borrowers could see their interest rates reset lower than they otherwise would have without the cuts.

One type of mortgage that was popular with prime borrowers during the boom was the so-called option ARM, which allows homeowners to choose each month from a variety of payments, including a minimum payment that doesn't even cover interest on the loan. As a result, with unpaid interest accumulating and house prices falling, some homeowners have seen the equity in their homes disappear and even head into negative territory. Lenders such as Calabasas (Calif.)-based Countrywide Financial (CFC), Seattle-based Washington Mutual (WM), and Charlotte (N.C.)-based Wachovia (WB) all have significant exposure to option ARMs.

Facing Foreclosure

Jay Brinkmann, the Mortgage Bankers Assn.'s vice-president for research, says the slumping home prices simply uncovered problems that borrowers could sidestep in the days of home buyer bidding wars and double-digit annual price increases. "Before, if somebody had a divorce or the main wage earner was injured and couldn't work, or some other issue, you would not have seen it because they would have sold their house and satisfied their mortgage," Brinkmann says. "Now if there's still the same level of job loss, more of those people end up in foreclosure because they can't sell."

Brinkmann says there are several scenarios in which a prime borrower with a record of on-time bill payments could now be facing foreclosure. A family that expected to move in a few years, for example, might have taken on an ARM expecting that when the time came to move, they'd easily be able to unload the home for a profit. Other borrowers might have taken on a large loan expecting their own finances to improve by the time the loans adjusted and their monthly payments ballooned.

"The magnitude of the [prime ARM foreclosure start rate] increase is somewhat large because we had a lot of activity in the last few years," says Robert Kleinhenz, deputy chief economist with the California Association of Realtors. "We thought the prime side of the market would be a steadying influence and what we had to focus on is the subprime market. That's not exactly true as the events are unfolding."

See the BusinessWeek.com slide show to learn which 20 states had the most foreclosures as a result of prime ARMs.

Gopal writes about real estate for BusinessWeek.com in New York .