Forecast: A Milder Mortgage Meltdown

This is the year thousands of homeowners with option adjustable-rate mortgages were supposed to default as their payments spiked. "Everyone identified option ARMs as a potential time bomb," says Guy Cecala, publisher of newsletter Inside Mortgage Finance. Low interest rates and a surge of early defaults mean the numbers probably won't be as bad as forecast, softening the blow to the housing market, where prices have resumed falling.

Introduced in the early 1980s, the option ARM gives borrowers a choice during an initial period, usually five years, of paying principal and interest, interest-only, or a minimum outlay covering only a portion of the interest. The loans gained popularity as housing prices soared in the past decade because the low initial payments allowed borrowers to qualify for homes they couldn't otherwise afford.

Many borrowers defaulted because they couldn't keep up with even the minimum payments or walked away because declining prices made their homes worth less than what they owed on them. Borrowers who chose to pay less than the full interest due saw the shortfall added to the principal. The problem with that approach is that the loans can reset sooner if a homeowner's balance reaches certain levels, usually 110 percent or 125 percent of the original amount. As a result, some borrowers saw their payments jump well before five years. "It's not that option ARMs weren't a bad way to finance homes," says George McCarthy, a housing economist at the Ford Foundation in New York. "It's just that the disaster already happened."

About $600 billion of the loans were made from 2005 through 2007, according to Inside Mortgage Finance. Lenders have revised terms on about 20 percent of option ARMs, sometimes switching them to a fixed rate, says Michael Fratantoni, vice-president for research at the Mortgage Bankers Assn. in Washington. Many more loans have disappeared through payoffs, refinancing, foreclosures, or sales in which the lender took less than the amount owed. About half of the loans issued from 2003 to 2007 remain outstanding, Fratantoni says.

For those homeowners who are still holding option ARMs, continuing low interest rates will cushion the impact of resets. An index tied to one-year Treasury yields commonly used as a benchmark to set interest rates on option ARMs stands at 0.29 percent. That is down from almost 5 percent at the beginning of 2007, according to data compiled by Bloomberg. The average borrower's monthly payments will increase 30 percent to 40 percent, Barclays Capital (BCS) estimated in a Jan. 7 report. Analysts a few years ago were forecasting that payments for some borrowers could double. "Of the borrowers who are still paying, the recast will not be a big deal," Fratantoni says. "It's not at all what people anticipated."

The prospect of fewer defaults is a plus for the housing market, which was burdened by 2.2 million foreclosed homes as of Dec. 31, according to data from Lender Processing Services (LPS) in Jacksonville, Fla. The S&P/Case-Shiller index of home values in 20 cities fell 1.6 percent in November from the year before, the biggest decrease since December 2009, the group said on Jan. 25. The gauge remains 30 percent below its 2006 high.

Yet the option ARM problem is far from over. A model developed by JPMorgan Chase (JPM) analysts predicts that 70 percent of remaining option-ARM loans that were bundled into bonds will eventually default. And a sudden increase in rates could trigger a new round of defaults. "Lots of lenders have taken action to stave it off, knowing it's a problem," says Jon D. Maddux, chief executive officer of in Carlsbad, Calif., which advises borrowers on strategic defaults. "They have extra time because rates are low. But when those rates go up, that's when we're going to see this problem happen."

The bottom line: The wave of defaults on option ARMs expected to slam the housing market this year may be less damaging than once feared.

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