Resets on exotic mortgages are still a major threat

It would be nice if the bad mortgages that set off the financial crisis were all cleaned up. Granted, you don't hear as much these days about subprime mortgages. But regrettably that does not mean that the mortgage problem is over. In fact, there are hundreds of billions worth of other kinds of mortgages that could and likely will still hurt investors and homeowners.

Do you own stock in Bank of America (BAC), J.P. Morgan Chase (JPM) or Wells Fargo (WFC)? If so, your investment may be vulnerable to something called an option Adjustable Rate Mortgage (ARM) -- $134 billion of these financial time bombs -- which let borrowers pick their monthly payment -- will see those payments reset to $1,053 -- up 63 percent by 2011, according to The Washington Post. Why have none of the builders of these financial stealth bombs paid the price?

That will be painful for these banks and for people who own real estate in some states -- all of whose names end with the letter a. And that's not all -- there's an even bigger problem with interest-only loans which enable a borrower to defer repayment of the loan principal for several years.

Why are these banks exposed to option ARMs of which $189 billion are outstanding? Because they each acquired big option ARMs issuers. Bank of America bought Countrywide, JPMorgan acquired Washington Mutual and Wells scooped up Wachovia. and the most vulnerable states are California, Florida, Nevada and Arizona -- which financed 75 percent of option ARMs -- and where home prices have plunged 48 percent since the second quarter of 2006.

Unfortunately, many of these option ARM mortgages were issued during the bubble years. Of the one million loans made between 2004 and 2007, only 3.5 percent have been modified between the borrower and lender which may reduce the chances of foreclosure. Meanwhile, delinquencies on these option ARMs are high -- 35 percent -- even before the resets have kicked in.

But guess what? There is an even bigger problem out there -- interest only loans. There are 2.8 million active interest-only home loans worth $908 billion -- that's over four times the size of the option ARM market.

And when the borrowers are forced to repay the principal, their payments will rise between 20 percent and 75 percent. And that's a shame because interest-only loans were issued in many of the same states as the option ARMs. That means the borrower hold notes against homes whose market value has declined significantly -- making it tough to refinance the loans.

And there are big numbers of these loans that will reset upwards in the next several years. By 2010, $71 billion of interest-only loans will reset, the next year $100 billion will reset. And after mid-2011, so will another $400 billion.

It would not surprise me if option ARMs and interest-only loans added hundreds of thousands of new foreclosures as a result of these resets. That should keep this housing and financial crisis dragging on for a decade or more.

While I think the borrowers who are already paying the price should have been more cautious, it's too bad nobody who inflicted these ticking time bombs on society has been brought to justice for their act of financial terrorism.

Peter Cohan is amanagement consultant, Babson professor and author of eight books, includingYou Can't Order Change. Follow him on Twitter. He owns Wells Fargo shares and has no financial interest in the other securities mentioned.

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