My View on Today's Econimic Issues - Part I

The Problem

In 1981 the mortgage industry created a new product called the Option ARM. The option ARM is a unique product, which introduced a new product to an industry that had been fairly uniform for half a century. The concept behind the option ARM is buyers generally have two periods of repayment. The first is anywhere between one to ten years with very low payments. The second period consists of the remaining balance of a 30 year total term with higher payments.

During the first period of repayment homeowners have the option to pay one of four amounts. The first option, or minimum payment, represents a negative amortization amount. A recent study by Fitch Ratings reported up to 80% of all option ARM borrowers make only the minimum payment. A negative amortization payment capitalizes the unpaid interest into the balance of the loan, which increases the loan balance every month.

The second payment option represents an interest only option. Homeowners selecting to pay this amount retain the same balance on their loan through the entire first period. No principal is ever paid down with this option.

The last two payment amounts represent a more conventional option. The third payment option represents a 30 year fully amortized payment. The fourth payment option represents a 15 year fully amortized payment.

At the end of the first repayment period the mortgage resets to a conventional type loan with the balance amortized over the remainder of the loan term. Due to severly relaxed lending standards borrowers were not required to show they were qualified for the loan during the second repayment period.

Many borrowers who qualified for option ARM’s from 2001 to 2005 cannot afford, and would not be qualified for, a fully amortized payment on a loan of the same amount over a 20-25 year term. Eighty percent of these loans reset to a rate higher than market, on a balance larger than the original, with a shorter term. All these factors can significantly drive up a borrower’s monthly payment. Homeowners often find themselves in financial trouble when these loans reset.

Until about 2001 the Option ARM was reserved for well qualified buyers. The events surrounding 9/11 dealt a blow to the economy and the US was headed for another recession. Looking for a way to create new business mortgage brokers and banks marketed this loan as an affordable option for the masses. During a time with very little regulation in the industry, these loans were easy to come by. No proof of income was required. Brokers advertised teaser rates as low as 1%. Many people were sucked in by this to good to be true marketing message.

Both potential homeowners and existing homeowners saw this as a dream come true. Brokers advertised a $500,000 loan with monthly payments of only $1,666.26. This would save a homeowner in the ballpark of $14,000 a year in mortgage payments. What brokers didn’t do was educate the consumer and read them the fine print.