Defusing the Option-ARM Time Bomb

Next: Defusing the Option-ARM Time Bomb

As if enough shoes hadn't already fallen on the beleaguered national housing market, there is still one, very big one left: the option-ARM bomb, er, shoe.

To recap, first came the now-infamous, sub-prime "Liar Loans": low or no-doc loans to borrowers with poor credit, putting nothing down, to buy homes in overheated housing markets. Such loans were characterized by low teaser rates and payments that quickly re-set much higher, typically within 2-3 years.

Sure enough, 2-3 years past the housing market's 2005 peak, the double whammy of negative equity and zooming payments sunk many of the sub-prime borrowers.

Now come the option-ARM borrowers -- apparently, legions of them.

The specialty of banks like Washington Mutual and Wachovia, these loans are literally financial time bombs: instead of amortizing principal, or even just paying interest, option-ARM borrowers can "opt" to make payments so low that they don't even cover the interest due.

What happens to the shortfall? It's added to the principal, a phenomenon innocuously known as "negative amortization." Lenders I've spoken with put the amount of outstanding option-ARM loans at about the same size as sub-prime loans, around $1.5 trillion.

Wanted: 'Financial MacGyver's'

So why haven't we heard more about them?

Three reasons.

One, it's hard to be heard in a Category 5 financial hurricane.

Two, they're heavily concentrated geographically. In markets like Florida, Southern California, and Las Vegas, they accounted for a significant percentage of all loans originated at the peak. In more staid markets like the Twin Cities (my focus), reputable lenders wouldn't touch them -- and now don't have exposure to them.

Third, and perhaps most significantly, the option ARM's have long fuses: five years, to be exact.

Yes, that's right: at the height of the housing market in 2004-2006, aggressive lenders, in their infinite wisdom, gave their shakiest borrowers five years to start making real payments (and you thought the local furniture store's "no interest till 2009" pitch was generous!).

That makes fallout from the biggest wave of option ARM's due to hit in 2010-2011.

Two Ways to Disarm

So what do you do now? There are really only two options, er, choices.

One. Re-float the housing market. Higher prices mean more homeowner equity. More homeowner equity means more wherewithal to refinance, and less incentive to default.

Unfortunately, to truly disarm the option-ARM bomb, housing prices would not only have to revisit the 2005 peak, they would have to substantially exceed it. That's because all those option-ARM borrowers now owe a lot more than they originally borrowed (thank you, negative amortization).

The odds of housing prices suddenly going up 50% or more in today's environment are about the same as NASDAQ hitting 6,000.

Two. Make sure the banks have lots and lots of capital.

Clearly, that appears to be the approach embraced by the Fed, the Treasury, and the banks themselves.

How else do you explain the otherwise anomalous behavior of a bank like Wells Fargo, Wachovia's purchaser, saying it's well-capitalized on Monday, "accepting" $25 billion in federal money on Tuesday, and selling $11 billion in stock on Wednesday?

Sure it's well-capitalized. Just like Fannie Mae, Freddie Mac, Bear Stearns, Lehman Bros, AIG . . .