Are Option ARMs Ready to Explode?

If you think we’re through with the sub-prime and foreclosure crises in the housing market – prepare yourself. There could be another shoe dropping and that shoe is the looming Option ARM crisis.

Option ARMs are typically 30-year adjustable rate mortgages that initially offer the borrower four monthly payment options: a specified minimum payment, an interest-only payment, a 15-year fully amortizing payment, and a 30-year fully amortizing payment. Option ARMs are also known as “pick-a-payment” or “pay-option” ARMs. Option ARMs are often offered with a very low teaser rate (often as low as 1%) which translates into very low minimum payments for the first year of the ARM.

The Fed has been trying to prevent a crisis in Option ARMs by keeping key interest rates at historic lows, thereby lessening the impact on borrowers when the interest rate on the Option ARM recasts. The most common rate that Option ARMs are pegged to is the Monthly Treasury Average (MTA) which takes the Monthly Yield on 1 Year Treasury Notes and averages them out over a year.

Under the terms of the typical Option ARM, the interest rate does not recast for a maximum of 5 years after the loan was originated if the MTA does not vary much. So by keeping the MTA low, the Fed’s actions only served to postpone the Option ARM crisis. The bulk of existing Option ARM loans were originated in 2005 and 2006 which means a huge number of loans will be recast over the next couple of years.

The result is an increasing amount of foreclosure activity on Option ARM loans that are being recast. How bad will it get? That depends a lot on the willingness of lenders to modify the loans, but it could get very bad.