SAN FRANCISCO - When Linda Martin refinanced the mortgages on three different houses nearly three years ago, she thought the lower monthly payments would help her save more money for retirement.
Instead, the Lakewood, Colo. skin-care specialist is sinking in financial quicksand amid a widening mortgage morass that's pulling down home prices and threatening to drag the U.S. economy into a recession.
"I'm hanging on by a thread, not knowing whether I am going to be living in a car in six months," said Martin, who declined to reveal her age.
Martin is among the multitude of borrowers saddled with "option" adjustable rate mortgages, risky loans that dangled bargain-basement introductory payments and also let borrowers defer a portion of interest payments until later years.
An even larger group is wrestling with another type of adjustable rate mortgage, or ARM, called "interest-only." Those loans allowed borrowers to pay just enough each month to cover the interest owed on the loan, leaving the balance of the outstanding debt unchanged.
While most of the mortgage market worries so far have focused on the huge losses flowing from the subprime home loans made to people with bad credit, the option and interest-only ARMs held by more creditworthy borrowers loom as another calamity in the making.
If the worst fears about the loans materialize, the economic damage would likely extend well beyond the United States because much of the debt has been packaged into securities sold to pension funds, banks and other investors around the world who were hungry for high yields. The fallout could also further depress housing prices, leaving U.S. consumers feeling poorer and less likely to buy the merchandise imported from overseas.
So far, less than 4 percent of the option and interest-only ARMs are delinquent, well below the 14 percent rate for the subprime market, where about $1.5 trillion in home loans are still outstanding, according to the most recent data from the research firm First American LoanPerformance.
But there is still reason to be alarmed because the trouble with option and interest-only ARMs still appears to be in its early stages. Many industry observers suspect the biggest problems will emerge during the next 16 months as shoddily underwritten ARMs made near the real estate market's peak in 2005 and 2006 climb to higher interest rates.
"Those loans are begging to blow up. This is a true financial crisis," said Christopher Thornberg, a principal with Beacon Economics, a consulting firm that has followed real estate market's ups and downs.
Lenders made an estimated $581 billion in option ARM loans during 2005 and 2006 while doling out nearly $1.4 trillion in interest-only ARMs, according to LoanPerformance. A recent study estimated about $325 billion of these loans will default. By comparison, about $212 billion in subprime loans were delinquent through May.
The initially low monthly payments on the exotic ARMs enabled more people to buy homes and enticed other borrowers to refinance their existing mortgages to free up cash for other purposes.
Now, the exotic ARMs are tormenting overextended homeowners, reckless lenders and shortsighted investors as the rates rise, dramatically driving up monthly loan payments against a backdrop of declining property values.
The conditions have deteriorated so much that Angelo Mozilo, chief executive of mortgage lender Countrywide Financial Corp., recently described the real estate slump as the worst since the Depression ended nearly 70 years ago.
Countrywide sent out another distress signal late Thursday in a regulatory filing that warned it's being forced to hold on to more loans than it wants to keep. "We believe the current environment of rapidly changing and evolving credit markets may provide increasing challenges for the financial services sector, including Countrywide," the Calabasas, Calif.-based company said.
Washington Mutual Inc., another major lender of option and interest-only ARMs, echoed those concerns in a similarly bleak Securities and Exchange Commission filing that warned the subprime problems are cropping up in higher-quality mortgages, too.
Option ARMs like Martin's are especially toxic when home prices start to shrivel.
Here's why: When borrowers pay the minimum monthly amount on an option-ARM, they aren't covering the amount of interest accruing on the loan. To compensate, lenders add the amount of unpaid interest to the mortgage's outstanding debt.
Option-ARMs also allow for a higher monthly payment to reduce the loan's principal, but most borrowers only make the minimum installment. At some lenders, 80 percent to 90 percent of the option-ARM borrowers are paying the minimum amount.
So, a homeowner who originally borrowed $250,000 under an option-ARM could end up owing an additional $5,000 to $10,000 after making the minimum monthly payment for a year, depending on the terms.
The negative amortization isn't as troubling when home prices are rising because the borrower could still be building more equity than debt.
But now that real estate prices are sliding, the additional debt created by option-ARMs raises the chances that the property will be worth less than the remaining amount owed on the loan - a perilous position known as being "upside down." The situation only becomes more worrisome as the rates on the loans adjust upward.
It's a scary scenario because many borrowers obtained their loans with little or no down payment, meaning they only had a small amount of equity to start. Nearly 18 percent of the first mortgages originated last year went to borrowers with no equity in the property, up from 5 percent in 2002, according to an analysis by First American CoreLogic, a research firm affiliated with LoanPerformance.
Other borrowers eroded their equity with second loans known as "piggyback" mortgages or lines of credit secured by their properties.
That means many ARM borrowers unable to afford their higher loan payments after their loans reset probably won't be able to extricate themselves by selling their homes. And refinancing into a more manageable mortgage is becoming increasingly difficult as suddenly leery lenders stop accepting application in an effort to avoid further headaches.
"It's a perfect storm that is going to lead to more foreclosures with severe downward pressure on home values," said George McCarthy, a housing economist with the Ford Foundation.
Martin doesn't think she is upside down on her loans yet, but knows she is getting uncomfortably close as home prices around her neighborhood continue to sag.
When Martin refinanced the mortgages on her home and two rental properties in October 2004, she said she owed a total of $735,000. The combined debt now stands at $777,000 and is growing by more than $2,000 each month.
Martin says she would have never refinanced if a mortgage broker hadn't misled her about how the new loans worked - a frequent complaint among borrowers with option-ARMs.
As she contacts lawmakers and attorneys in search of help, Martin isn't focused on retirement any more. She is more worried about making sure she won't lose her home.
"I very well may be looking at a foreclosure case," she said. "I may just have to walk away from these loans."
Martin's situation isn't unique.
Although they have been around since 1981, option-ARMs weren't common until the past few years. They previously had been aimed at high-paid workers who depended on large commissions and bonuses.
But option-ARMs began making their way into the mainstream in 2004 as commission-hungry brokers and profit-driven lenders tried to capitalize on intense home-buying demand driven by soaring real estate prices.
Last year, negative amortization loans accounted for 9.9 percent, or $350 billion, of all mortgages nationwide, up from just 0.4 percent as recently as 2003, according to LoanPerformance.
The mortgages were particularly popular in high-priced real estate markets like California or areas like Nevada, Arizona and Florida, where speculators were buying homes as investments instead of places to live.
Option-ARMs accounted for nearly 22 percent of the mortgages made in California during 2006, according to LoanPerformance. Other hot spots included: Nevada (15 percent), Hawaii (13.3 percent), Florida (12.2 percent), Washington (10.9 percent) and Arizona (10.6 percent).
If many of those loans go bad, major option-ARM lenders will likely be forced to erase some of the profits that they have already booked from the exotic mortgages. Under an accrual accounting method allowed by regulators, option-ARM lenders routinely record the uncollected interest as income even though the money may never be paid.
This phantom income has swelled along with the use of option-ARMs. For instance, Washington Mutual recognized $706 million in uncollected interest from negative amortization loans during the first half of this year, a 61 percent increase from the same time last year.
Investors already appear to be seeking shelter from the possible financial storm ahead.
Washington Mutual's stock price has dropped by 21 percent so far this year while Countrywide's shares have shed 36 percent. Another major option-ARM lender, IndyMac Bancorp Inc., has been even harder hit, with its stock plunging by 56 percent since the end of last year. The sharp downturn in those three stocks alone have wiped out a combined $24 billion in shareholder wealth.
Thornberg is among the economists who believes the mortgage market turmoil could lead to a recession during the next year. "This snowball is just 20 percent down the hill. It's nowhere near the bottom," he said.
The biggest risks appear concentrated among ARMs that began with an initial interest rate of 4 percent or less. CoreLogic estimates 1.4 million ARMs totaling $521 billion fell into this danger zone from 2004 through 2006. That represented nearly 10 percent of the $5.38 trillion in home loans originated during that period.
Christopher Cagan, CoreLogic's director of research and analytics, predicts about 1.1 million ARMs totaling $325 billion will sink into foreclosure as rising monthly payments squeeze borrowers. After accounting for the money recovered through property sales, he expects the losses from the fallout to total $112 billion, with the damage spread out over six years.
Although significant, the losses won't be large enough to topple the United States' $12 trillion economy, Cagan said. "This is the turning of a business cycle," he said. "There will be some pain, but most people will be fine and most lenders will be fine."
That's little consolation to homeowners like Andrew Villaruz, a 43-year-old hospital administrator who said he refinanced into an option-ARM late last year without understanding what he was getting into. His loan balance quickly grew from $364,000 to $370,000, a shift that become even more disturbing to him as he watched more foreclosure signs go up around his Sacramento neighborhood.
Coupled with other costs lumped into the loan, Villaruz figures he lost about $25,000 by the time he found another lender willing to refinance him into a more conventional mortgage. He sheepishly acknowledged he had never heard of a negative amortization loan until he had one. He knows enough now to stay away from them.
"They might be good for people who make a lot of money, but they don't pan out for the average person," he said. "They just don't make sense."