High-risk mortgages turning into toxic mess

AP/ Fotografía: Ed Andrieski / msnbc
San Francisco (13/08/07)

Experts believe the biggest problems will emerge during next 16 months

Linda Martin stands in front of one of her rental homes in Arvada, Colo. She owns a home and two rental properties in the area and refinanced the loans on all three houses back in October 2004 when rates were low. On the advice of a mortgage broker, she got into three mortgages totaling $775,000 that promised her a great deal and have turned out to be a financial sinkhole.

When Linda Martin refinanced the mortgages on three different houses nearly three years ago, she thought the lower monthly payments would help her save more money for retirement.

Instead, the Lakewood, Colo. skin-care specialist is sinking in financial quicksand amid a widening mortgage morass that’s pulling down home prices and threatening to drag the U.S. economy into a recession.

“I’m hanging on by a thread, not knowing whether I am going to be living in a car in six months,” said Martin, who declined to reveal her age.

Martin is among the hundreds of thousands of borrowers saddled with “option” adjustable rate mortgages, risky loans that dangled bargain-basement introductory payments and also let borrowers defer a portion of interest payments until later years.

Millions of other borrowers are wrestling with another type of adjustable rate mortgage, or ARM, called “interest-only.” These loans allowed borrowers to pay just enough each month to cover the interest owed on the loan, leaving the balance of the outstanding debt unchanged.

While most of the mortgage market worries so far have focused on the huge losses flowing from the subprime home loans made to people with bad credit, the option and interest-only ARMs held by more creditworthy borrowers loom as another calamity in the making.

If the worst fears about these loans materialize, the economic damage would likely extend well beyond the United States because much of the debt has been packaged into securities sold to pension funds, banks and other investors around the world who were hungry for high yields. The fallout could also further depress housing prices, leaving U.S. consumers feeling poorer and less likely to buy the merchandise imported from overseas.

So far, less than 4 percent of the option and interest-only ARMs are delinquent, well below the 14 percent rate for the subprime market, where about $1.5 trillion in home loans are still outstanding, according to the most recent data from the research firm First American LoanPerformance.

But there is still reason to be alarmed because the trouble with option and interest-only ARMs still appears to be in its early stages. Many industry observers suspect the biggest problems will emerge during the next 16 months as shoddily underwritten ARMs made near the real estate market’s peak in 2005 and 2006 climb to higher interest rates.

“Those loans are begging to blow up. This is a true financial crisis,” said Christopher Thornberg, a principal with Beacon Economics, a consulting firm that has followed real estate market’s ups and downs.

Lenders made an estimated $581 billion in option ARM loans during 2005 and 2006 while doling out nearly $1.4 trillion in interest-only ARMs, according to LoanPerformance. A recent study estimated about $325 billion of these loans will default, leading to more than 1 million homeowners relinquishing their property to lenders. By comparison, about $212 billion in subprime loans were delinquent through May.

The initially low monthly payments on these exotic ARMs enabled more people to buy homes and enticed other borrowers to refinance their existing mortgages to free up cash for other purposes.

Now, the exotic ARMs are tormenting overextended homeowners, reckless lenders and shortsighted investors as the teaser rates rise, dramatically driving up monthly loan payments against a backdrop of declining property values.

The conditions have deteriorated so much that Angelo Mozilo, chief executive of mortgage lender Countrywide Financial Corp., recently described the current real estate slump as the worst since the Depression ended nearly 70 years ago.

Countrywide sent out another distress signal late Thursday in a regulatory filing that warned it’s being forced to hold on to more loans than it wants to keep. “We believe the current environment of rapidly changing and evolving credit markets may provide increasing challenges for the financial services sector, including Countrywide,” the Calabasas-based company said.