Interesting Times

... These “pay option” adjustable-rate mortgages gave borrowers a choice of payments each month. They also carried a feature that came as a nasty surprise to some borrowers, called "negative amortization." If the homeowner opted to pay less than the full monthly amount, the difference was tacked onto the principal. When the loan automatically “recasted” in five or 10 years, the owner would be locked into a new, much higher, set monthly payment.

Now, as the housing recession deepens, a coming wave of payment shocks threatens to bring another surge in defaults and foreclosures as these mortgages “recast” to higher monthly payments over the next two years.

“The next wave (of foreclosures) is coming next year and in 2010, and that is primarily due to these pay-option ARMS and the five-year, adjustable-rate hybrid ARMS that are coming up for reset,” said William Longbrake, retired vice chairman of Washington Mutual. The giant Seattle-based bank, which collapsed this year under the weight of its bad mortgage loans, was one of the biggest originators of pay-option ARMs during the lending boom.

The next wave may be even more difficult to handle than the last one.

“It’s going to get tougher to modify loans as these option ARMs come into their resets," Federal Deposit Insurance Corp. Chairwoman Sheila Bair told msnbc.com this week. "Those are more difficult than the subprime and traditional adjustable rates to modify because there is such a huge payment differential when they reset."

...  The first wave of home foreclosures that hit in late 2006 and early 2007 followed the resetting of subprime adjustable mortgages with two- and three-year "teaser rates" written during the height of the lending boom earlier in the decade. But pay-option ARMs — which often don't "recast" for five years — have a longer fuse. Unless defused by aggressive public and private foreclosure prevention programs, the bulk of these loans will explode to higher payments in 2009 and 2010.

The scope of the problem was highlighted in September in a study by Fitch Ratings, one of the bond rating agencies that assesses the risk of defaults on mortgage-backed investments. Of the $200 billion in option ARMs outstanding, Fitch estimates that some $29 billion will recast in 2009 and another $67 billion in 2010. That could cause delinquencies on these loans to more than double, Fitch said.

To make matters worse, only 17 percent of option ARMs written from 2004 to 2007 required full documentation. Many of the borrowers who took out these loans also took out a second mortgage, which means they likely have little or no equity in their home, according to the report. That means many could owe more than their house is worth when the loan recasts to unaffordable payments.

Heavy losses from investments backed by pay option ARMs were a major cause of the demise of Wachovia and Washington Mutual, one of the largest originators of option ARMs during the height of the lending bubble.

... Since the housing bubble began to deflate in 2006, roughly 3 million homes have been lost to foreclosure. Over the next two years, another 3.6 million are expected to lose their homes, according to Moody’s Economy.com chief economist Mark Zandi.

Many of the most problematic loans — those sold with a two- or three-year low “teaser” rates — have already reset to higher levels. Those resets have been a major force in the first wave of foreclosures, which rose from 953,000 in 2006 to nearly 1.8 million last year and are on track to hit 3.1 million this year, according to First American CoreLogic, which tracks real estate data.

And the pace of foreclosures is still climbing. More than 259,000 U.S. homes received at least one foreclosure-related notice in November, up 28 percent from the same month last year, according to RealtyTrac.

Though the pace dropped slightly from the previous month, there are indications "that this lower activity is simply a temporary lull before another foreclosure storm hits in the coming months," said RealtyTrac CEO James Saccacio.

Mortgage delinquencies — homeowners who have fallen behind but not yet been hit with foreclosure — are also on the rise, according to the latest quarterly survey from the Mortgage Bankers Association. A record one in 10 American households with mortgages was overdue on payments or in foreclosure as of the end of September.

... “In the neighborhoods that have concentrations of subprime loans you already have concerns about crashing neighborhoods with too many vacant houses and crime rises,” said Longbrake. “The same thing will be true for these option ARMs. They are concentrated in particular neighborhoods and particular locales around the country."

Fitch estimates that the average potential payment increase would be 63 percent, or about $1,053 a month — on top of the current average payment of $1,672.

The impact on the millions of American families losing their homes is devastating. But the foreclosure fallout is being felt around the world. As the U.S. slides deeper into recession, foreclosures are the root cause of a downward spiral that threatens to prolong and widen the economic impact: