Option ARM Loans Turn into Nightmares

"Flexible" loans for small business owners now threaten them with bankruptcy and home foreclosure at the same time

Entrepreneur Michael Bissell worries about losing his business, his house, or both. His 10-year-old Web design firm in Portland, Ore., is struggling as customers fall behind on their bills. To cover salary and other expenses, Bissell tapped into his home last year for extra cash, relying on his exotic mortgage, which gives him the option to pay less than the monthly interest and principal for a while. But that source of money is running dry: The payment on his home loan will soon jump significantly. "I have no padding," says Bissell.

Small business owners are at the epicenter of two dangerous forces: the housing bust and the recession. During the boom, many entrepreneurs pulled money out of their homes to start businesses or fund existing operations. Some, like Bissell, relied on an especially pernicious type of loan, the option adjustable-rate mortgage, which allowed borrowers to determine the size of their monthly payment. When the businesses ran into trouble, many homeowners started paying the minimum, tacking the extra interest and principal onto the loan.

Many mortgages are resetting and triggering higher payments—either because the terms of the loans dictate such a reset or the balances far exceed the value of the underlying homes. That's leaving entrepreneurs scrambling to come up with more money as their businesses are suffering—a double whammy on a fragile economy. Borrowers with option ARMs can't easily refinance, since they often owe more on the loans than their homes are worth. And loans for small businesses have all but dried up. "Small business [owners] are hurting, and they're scared," says Chad Moutray, chief economist in the U.S. Small Business Administration's Office of Advocacy.

In the era of easy credit, mortgage brokers targeted small business owners, marketing option ARMs as cash-management tools. An executive at now-defunct lender GreenPoint Mortgage called such loans "a low-cost and low-hassle way for small business owners to finance…growth" in a trade publication back in 2004. Bill Challas, a broker at LG Loan Group, saw entrepreneurs as ready buyers: "If you could pay $1,000 less a month on a loan, wouldn't you?"

California Nightmare

Statistics are scarce because lenders don't break down loan volume by types of borrowers. But sales of option ARMs to all homeowners, according to research firm First American CoreLogic, soared more than 75%, to $255 billion, from 2005 to 2007—the height of the housing frenzy. Small business loans backed by the government dropped 4.5% in the last two years of the boom.

The problem is acute in California, where small businesses account for more than 50% of employment. Homeowners in the state are liable for 60% of all the outstanding option ARMs nationwide, according to Credit Suisse (CS). Officials are trying to forestall a wave of business failures. Preston DuFauchard, commissioner of California's Corporations Dept., is pressing large lenders to modify the loans. "California small businesses are at risk, since they were targeted for these toxic mortgages," says Samuel D. Bornstein, a professor at Kean University in Union, N.J.

Such efforts come too late for Pamela Plouffe of Pine Mountain Club, Calif. She refinanced her home in 2003, extracting $50,000 to buy an apparel business. Last year her monthly mortgage payment jumped from $900 to $1,700 as customers dwindled. The bank foreclosed in October. Says Plouffe, 53: "I've got to start over."

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