The Next Real Estate Crisis

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Blue bars on the chart represent the recast schedule if all the loans were to recast five years after origination date. Gray bars represent the expected schedule of option ARM resets, which show loans recasting sooner after hitting the principal cap. Credit Suisse

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Option ARMs, which were originally designed for self-employed people with fluctuating incomes, gained popularity with other workers during the peak of the real estate boom in 2004, when rapidly rising home values would have otherwise kept many buyers out of the market. The loans, which were generally given to borrowers with better-than-subprime credit, give homeowners the option of making a minimum monthly payment, which covers none of the principal and only a portion of the interest, the rest of which is added to the loan balance. With years of unpaid interest accumulating and house prices falling, some homeowners have seen their equity disappear and now owe even more than their initial loan balance.

The loans automatically recast after five years, but many will recast sooner as loan balances hit specific principal caps—typically between 110% and 125% of the initial loan amount. Many of these loans are expected to recast within the next two years, meaning that borrowers' monthly payments will swell to include both principal and interest.

Walking Away from a Collapse

Some borrowers say they signed up for the complicated loans without understanding the terms, or expected to be able to refinance or sell their homes before the loans recast. Instead, home prices fell and the credit crunch made refinancing impossible for many borrowers.

Some homeowners are simply walking away because with their equity vanishing, there's little incentive to stay.

William Purdy, a lawyer at Simmons & Purdy in Soquel, Calif., a firm that specializes in home refinance issues, said some borrowers with option ARMs are defaulting before the loans recast because they couldn't afford even marginal increases in the minimum payments.

"It's a ticking time bomb inside your house that you can't get rid of," Purdy said. "They can try to slow down the inevitable, but sooner or later their loan is going to cap. …This year is going to be a blood bath. Next year, we'll start out just about the same."

Crushed by the Slump

The option ARM was initially a blessing and then a curse for Deborah Shaw, a 52-year-old systems analyst for Santa Cruz County, Calif. In 2004 she bought a $575,000 two-bedroom house with her boyfriend with a 40-year fixed mortgage. But when she and her boyfriend split, Shaw could no longer make the payments. She refinanced into an option ARM, which allowed for a $1,600 minimum payment (she was paying $2,300 on the fixed loan).

Shaw planned to avoid a recast by selling the house in a couple of years, but the housing slump changed everything.

Shaw now thinks her loan has already recast, which means that her monthly payment would more than double. Shaw doesn't know for sure, because she stopped answering her lender's daily phone calls and, since April, stopped making payments entirely. She says foreclosure is her only option.

"I call the house my albatross," Shaw said. "I feel a sense of relief knowing I won't have that house to deal with anymore. I'm not looking forward to moving and selling everything. But I am looking forward to not having stress about something I can't afford."

New FHA Loan Guarantees

But options are available—even if refinancing isn't possible. Lenders have been working with borrowers to reduce loan amounts and interest rates and, in some cases, simply accept the deed in lieu of foreclosure.

The Mortgage Bankers Assn. says it appears that a growing number of homeowners are avoiding foreclosure by getting help from the Hope Now hotline (888 995-HOPE), a mortgage-counseling phone line backed by lenders and the federal government that gets 4,000 calls a day. Hotline counselors help borrowers negotiate with banks and offer advice on refinancing options. Even though foreclosure rates are rising in California and Florida, they've slowed elsewhere, the bankers association said.

Some callers to the hotline have complained about long wait times, but the group says it has beefed up its counseling staff and now gets to calls quickly.

Other option ARM borrowers could benefit from government plans now in the works. A bill approved by the House in May would allow the Federal Housing Administration to guarantee up to $300 billion in new loans to help homeowners facing foreclosure. Borrowers could get more affordable loans worth no more than 90% of the home's value, meaning that participating lenders would have to take a significant loss on the loan. The bill was sponsored by House Financial Services Committee Chairman Barney Frank (D-Mass.). Senate Banking Chairman Christopher Dodd (D-Conn.) has a similar measure.

Foreclosure Is Not Inevitable

"The fact is that people didn't really understand the transaction at the outset and were counting on being able to refinance when the loan got recast," said Colleen Hernandez, president of Minneapolis nonprofit Homeownership Preservation Foundation, which owns and operates the hotline. "That combination means a lot of risk, a lot of danger in the situation. But it isn't inevitable that they foreclose, and foreclosure isn't the best option."

Moe Bedard, founder of LoanSafe.org in Corona, Calif., a free online forum that helps homeowners negotiate loan modifications, said the larger problem is that banks, many of which laid off scores of loan officers, are so swamped that many borrowers can't get the attention they need.

Many California homeowners, including some with $2 million homes, are simply making their minimum payment, waiting for the recast. Then they plan to walk away, even if it damages their credit, Bedard said.

"A lot of people are just walking," Bedard said. "It's just a business decision; they don't have a lot of skin in the game." But for many others it will be devastating.

Business Exchange related topics:
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Subprime Geopolitics

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