Reports indicate that a second “Mortgage-Bomb” is yet to detonate – Alt-A mortgages and Option Arm’s.  These loans took off like a shot as real estate prices went through the roof.  Why?  Simple.  These loan programs allowed just about anybody to qualify without any income verification whatsoever, often without verifying the source of the borrowers funds for down payment and closing costs either.   As long as a borrower’s credit score wasn’t completely in the dumps, the loans were approved.  It allowed people to get larger mortgages than they would have normally been able to get enabling them to buy at prices they should have been walking away from.

 But looking back, hindsight is 20/20 isn’t it? At the time people were so caught up in the feeding frenzy that they overlooked that they were overpaying for their properly. With the mentality that no one wanted to miss out on these great deals, borrowers locked into payment structure that would come back aggressively to haunt them.

 One of the “clauses” of these loans is that it could adjust itself dynamically based on several factors. What this means is that payments can jump up drastically, especially for people whom were paying on the interest only. This is called negative amortization and is one of the key aspects of the Option Arm.

The Option Arm loan program had been around since the early 1980’s (remember Home Savings of America?). The Option Arm had a lot of bells and whistles for prospective borrowers. These bells and whistles often made borrowers overlook the fact that were assuming the risk of rising interest rates because the loan is an adjustable rate mortgage. But interest rates have been in a multi-generational downward trend, keeping the actual rates for these borrowers low.

So what caused Option Arm loans to rise in popularity after 20 years of being a small piece of the pie? Well two reasons. The first is that Option Arm loans do not verify the income of the borrow. “Stated Income” thus holds as the qualifying factor for the loans. Many over the years have referred to this practice as qualifying for “Liar Loans” and with the market cost dramatically increasing, the Option Arm has become quite popular.

But the second reason for the increase in Option Arm loans is a direct result on how brokers adjusted the loans margin. Lenders placed a higher value on the loan based on the margin that the loan came with. Loan officers were paid more in commission if they sold the loan with a higher margin rate. Since many homeowners don’t understand the full complexity involved with margins, the sharks in the loan market had the upper hand. Everyone offered the same “start rate” so all the offers seemed very much the same. But these sharks (mortgage brokers, loan officers, and employees of banking operations ) would simply increase the margin to gain the maximum in commission.

RESPA documents were (and still are, in my opinion) woefully inadequate. So borrowers took these loans without really understanding how they worked. Fortun ately, most of the loans are tied to short term interest rates such as the MTA – the 12 month moving average of the 1 year t-bill which has been below 1% since November of 2008. The worst of these loans went out with a 3.5% margin, so the reset rate for these loans will be low.  Most people will be okay as long as short term interest rates remain low.

 Ultimately however, when the economy begins to pick up, the rates will start to increase ; and this is where the time bomb explodes. In a consumer driven economy, the borrowers whom are trapped in a Option arm might do themselves a favor by not spending the “praised” government stimulus packages by putting it away instead of buying anything. But I suppose it’s a matter of time before this problem rears its head, so homeowners.