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High-Risk Mortgages Become Toxic Mess

Option-ARMs accounted for nearly 22 percent of the mortgages made in California during 2006, according to LoanPerformance. Other hot spots included: Nevada (15 percent), Hawaii (13.3 percent), Florida (12.2 percent), Washington (10.9 percent) and Arizona (10.6 percent).

If many of those loans go bad, major option-ARM lenders will likely be forced to erase some of the profits that they have already booked from the exotic mortgages. Under an accrual accounting method allowed by regulators, option-ARM lenders routinely record the uncollected interest as income even though the money may never be paid.

This phantom income has swelled along with the use of option-ARMs. For instance, Washington Mutual recognized $706 million in uncollected interest from negative amortization loans during the first half of this year, a 61 percent increase from the same time last year.

Investors already appear to be seeking shelter from the possible financial storm ahead.

Washington Mutual's stock price has dropped by 21 percent so far this year while Countrywide's shares have shed 34 percent. Another major option-ARM lender, IndyMac Bancorp Inc., has been even harder hit, with its stock plunging by 55 percent since the end of last year. The sharp downturn in those three stocks alone have wiped out a combined $24 billion in shareholder wealth.

Thornberg is among the economists who believes the mortgage market turmoil could lead to a recession during the next year. "This snowball is just 20 percent down the hill. It's nowhere near the bottom," he said.

The biggest risks appear concentrated among ARMs that began with an initial interest rate of 4 percent or less. CoreLogic estimates 1.4 million ARMs totaling $521 billion fell into this danger zone from 2004 through 2006. That represented nearly 10 percent of the $5.38 trillion in home loans originated during that period.

Christopher Cagan, CoreLogic's director of research and analytics, predicts about 1.1 million ARMs totaling $325 billion will sink into foreclosure as rising monthly payments squeeze borrowers. After accounting for the money recovered through property sales, he expects the losses from the fallout to total $112 billion, with the damage spread out over six years.

Although significant, the losses won't be large enough to topple the United States' $12 trillion economy, Cagan said. "This is the turning of a business cycle," he said. "There will be some pain, but most people will be fine and most lenders will be fine."

That's little consolation to homeowners like Andrew Villaruz, a 43-year-old hospital administrator who said he refinanced into an option-ARM late last year without understanding what he was getting into. His loan balance quickly grew from $364,000 to $370,000, a shift that become even more disturbing to him as he watched more foreclosure signs go up around his Sacramento neighborhood.

Coupled with other costs lumped into the loan, Villaruz figures he lost about $25,000 by the time he found another lender willing to refinance him into a more conventional mortgage. He sheepishly acknowledged he had never heard of a negative amortization loan until he had one. He knows enough now to stay away from them.

"They might be good for people who make a lot of money, but they don't pan out for the average person," he said. "They just don't make sense."


AP Business Writer Sandy Shore in Denver contributed to this story.

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© 2007 The Associated Press