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High-Risk Mortgages Become Toxic Mess
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.
Washington Mutual Inc., another major lender of option and interest-only ARMs, echoed those concerns in a similarly bleak Securities and Exchange Commission filing that warned the subprime problems are cropping up in higher-quality mortgages, too.
Option ARMs like Martin's are especially toxic when home prices start to shrivel.
Here's why: When borrowers pay the minimum monthly amount on an option-ARM, they aren't covering the amount of interest accruing on the loan. To compensate, lenders add the amount of unpaid interest to the mortgage's outstanding debt.
Option-ARMs also allow for a higher monthly payment to reduce the loan's principal, but most borrowers only make the minimum installment. At some lenders, 80 to 90 percent of the option-ARM borrowers are paying the minimum amount.
So, a homeowner who originally borrowed $250,000 under an option-ARM could end up owing an additional $5,000 to $10,000 after making the minimum monthly payment for a year, depending on the terms.
The negative amortization isn't as troubling when home prices are rising because the borrower could still be building more equity than debt.
But now that real estate prices are sliding, the additional debt created by option-ARMs raises the chances that the property will be worth less than the remaining amount owed on the loan _ a perilous position known as being "upside down." The situation only becomes more worrisome as the teaser rates on the loans adjust upward.
It's a scary scenario because many borrowers obtained their loans with little or no down payment, meaning they only had a small amount of equity to start. Nearly 18 percent of the first mortgages originated last year went to borrowers with no equity in the property, up from 5 percent in 2002, according to an analysis by First American CoreLogic, a research firm affiliated with LoanPerformance.
Other borrowers eroded their equity with second loans known as "piggyback" mortgages or lines of credit secured by their properties.