Loose lending practices extended beyond subprime during the housing boom. Option ARMs accounted for up to 90 percent of the profits some lenders made in the hottest housing markets.

Although option ARMs were originally created in 1981 as a financial tool for the wealthy, lenders began using the risky loans to solve home affordability problems for the masses as early as 2003.

Analysts estimate lenders issued nearly $400 billion in option ARMs to as many as 1.3 million borrowers in 2004 and 2005 alone. Banks continued to hand out just as many option ARMs in 2006 even though it was clear housing was starting to slump.

Many of these loans were issued to borrowers with top-tier credit ratings and stated incomes. It is unknown how many of the borrowers understood how option ARMs work or how many borrowers exaggerated their income to qualify for the loans.

The Mortgage Asset Research Institute, which investigates lending fraud, suggests the number of borrowers who exaggerated income could be as high as nine out of ten. In a study of 100 stated income loans, 90 percent of borrowers exaggerated income by five percent or more; nearly 60 percent exaggerated income by 50 percent or more.

Option ARMs became popular because they are very flexible. Borrowers can choose to leave the loan balance untouched, pay interest only, or pay some or all of the interest and principal. The catch is that when a borrower makes only the minimum payment, the loan balance rises.

Three to five years later, all of the options disappear. It is not unusual for a borrower owe more than when they started and to see payments double or even triple.

Since 80 percent of option ARM borrowers make only the minimum payment every month (according to Fitch Ratings), there are a lot of loan balances rising even as house values are falling.

Not surprisingly, delinquencies are mounting. Delinquencies are in the double digits in many areas of California and nearly ten percent of the option ARMs made in 2005 were at least 60 days past due, according to mortgage researcher First American Loan Performance’s latest study.

How Bad Will the Crisis Get?

It’s hard to say exactly how many option ARMs were made over the last few years or when the delayed default waves will hit. Banks are not required to report the number of option ARMs they underwrite, which means few choose to do so.

Those who have made reports show significant increases in the use of option ARMs as well as a significant gain in profits. The gains are questionable because of the way banks handle their accounting.

It is standard practice for banks to count the highest possible amount of an option ARM payment versus the actual amount as revenue. This is true even when borrowers make the minimum payment and nothing more. In short, banks are claiming future revenue now without knowing whether or not they will ever see that revenue.

It sounds like a scam, but it is completely legal under Generally Accepted Accounting Principles (GAAP). The problem is that banks will probably never see the phantom revenue they have already claimed. When borrowers run out of pay options and maximum amortization levels are reached, the game will be up.

Exposure of Select Companies

• Countrywide Financial Corp made about a quarter of all option ARMs last year, according to S & P analysts. Bank of America, if it does indeed acquire Countrywide, will inherit a $30 billion remaining option ARM portfolio.
• Wachovia is in a similar predicament. The company acquired an option ARM portfolio of about $80 billion when it acquired Golden West. Many of the loans in the portfolio are the stated income sort and were made to borrowers with lower credit scores.   
• WaMu has more than $57 billion in option ARMs on its books. Add that to WaMu’s $59.1 billion in regular home-equity loans, $17.3 billion in subprime mortgages and $2.7 billion in subprime home-equity loans, and it is clear to see that half of the thrift’s portfolio consists of loans in high-risk categories.
• Downey Financial Corp. is now being referred to as “the canary in the coal mine.” About three-quarters of Downey’s loan portfolio is made up of option ARMs. The rest consists mainly of loans that offer similar interest only payments.
• Other lenders, like BankUnited Financial Corp, IndyMac Bancorp and Wells Fargo, are also expected to be hit hard. All three lenders got into the option ARM game and issued more loans than they should have.