What's an "Option ARM"?

Its a loan that is also known as a "negative amortization loan". That is, you have "options" as a borrower. You can:

• Pay the full principle and interest every month (what conventional mortgage folks do)
• Pay only the interest due and ignore the principle
• Pay LESS than the full interest amount, based on a lower rate (usually a "teaser" rate) and allow the rest of the interest to be put back into the principle.

This is a popular product for people who can't qualify for mortgages with the full P&I payment. Why? Well, it cuts the P&I - often by half or even more over a fully-amortized product.

The problem is that these loans typically all reset interest rates in either 1 or 2 years, and what's worse, when the negative amortization reaches a limit - typically 110% of the original line - they "hard reset" - that is, you get both an interest rate reset AND you must make a full P&I payment from that point forward.

This event basically always causes your payment to double if you were paying the "minimum option", and it can cause it to TRIPLE in certain cases, especially if you go all the way to the wall and interest rates have risen since you took the loan!

Many people who took these loans did so expecting to refinance out before the "bomb" went off.

But this is kinda like taking a box of dynamite for someone and being given $1,000, lighting a long fuse sticking out of the box, then driving around in your car looking back in the mirror every few minutes to see how much fuse is left.

All the time you're betting that SOMEONE will want that box of dynamite at a price that lets you keep some of that $1,000 - before the fuse runs out.

And oh, by the way, its waterproof fuse and wrapped in kevlar - you can't put it out nor can you cut it short.

What happens to you as the fuse gets shorter? The bids get higher. When you've got an hour's worth of fuse left, the guys tell you "I'll take that box of dynamite for $500 from you". You say "naw, I want more." Then there's 15 minutes left, and its "I'll take it for $250". Naw.....

Then you get down to 5 minutes of fuse left and the only guy who will take the box wants you to pay him $5,000. You don't have it. At three minutes, its $10,000. You don't have that either. With one minute to go, that box suddenly will cost you $100,000 to get rid of.... which of course, you don't have.

You end up sitting in the car saying "f%%% me!" as you watch the fuse disappear inside.....

Just in the last couple of months these loans have started to hit the hard caps and reset. This is totally under reported right now and it is not limited to the "subprime" market. Indeed, most "Option ARM" loans are written for people with VERY GOOD credit!

Virtually EVERY lender has a significant portion of their loan portfolio in these "Option ARM" products. Some are as high as 30%, but there are very, very few lenders with insignificant (below 5%) exposure to this "bomb."

What happens if you can't refinance because your loan-to-value is too high? You're screwed. You either make the payments or your house goes into foreclosure.

This is what I was alluding to yesterday.... and why this "subprime" thing is being grossly misreported.

This is NOT limited to "poor credit risks".

Disclosure: I'm short or hold PUTs on several companies in this sector.