A great shift toward adjustable mortgages helped push America's housing boom into high gear. Now, as the boom unwinds, the riskier side of those mortgages is coming home to roost.
The ultimate impact of all those "teaser" interest rates, the "no money down" mortgages, and exotic loans where homeowners' debt can rise over time will be muted somewhat, economists say, because it will be spread over the rest of this decade.
But that doesn't necessarily mean the mortgage shakeout will be easy. And for many individual borrowers, finance experts say, the sad result will be foreclosure.
"We just really don't have any precedent to say, 'This is how bad it can get,' " says Rick Sharga of RealtyTrac, which follows trends in foreclosure. "The homeowner who stretched to buy a house in the first place could find himself or herself in very serious financial trouble very quickly."
Economists generally don't believe the soaring popularity of "exotic" or nontraditional mortgages since 2004 will cause the kind of problems that push the nation into a recession. But foreclosure rates are already rising, and federal regulators are moving to develop new rules in a bid to keep banks from making loans to people who can't pay.
At the very least, routine shifts like the phaseout of "teaser" interest rates will crimp the purchasing power of many borrowers, sucking some momentum out of a consumer-led US economy.
It's the down side of what for years has been viewed as a positive trend: Ever-expanding choices in the realm of mortgage financing have helped millions of borrowers and boosted homeownership to record levels nationwide.
In 1990, the last time the nation was entering a real estate slowdown, less than 10 percent of home loans were ARMs, adjustable-rate mortgages. For the first half of this year, that number is 46 percent of the total, measured in dollar volume, says Richard Brown, chief economist at the Federal Deposit Insurance Corp.
Of all the adjustable-rate loans, 63 percent of them this year have been nontraditional: either "interest only" loans (it's up to the buyer whether to pay any principal to build home equity) or "option ARMs," which give borrowers a choice of several possible payments each month. Even fixed-rate loans today can be "interest only."
The biggest trouble lies with the adjustable loans that begin with artificially low interest rates. Those rates may only last for a month, a year, or two years, and then comes a "payment shock" as the rates reset in ways that can double the required payments.
Earlier this year, an analysis by First American Real Estate Solutions in Santa Ana, Calif., estimated that $368 billion in adjustable-rate mortgages originated in 2004 and 2005 are at risk of default because of this pattern. Many more borrowers with traditional ARM loans also face the prospect of rising interest rates, but of a more manageable magnitude.
"This translates into ... 1.8 million families that are at risk as a result of the possibility of default and another 500,000 that are likely to go into foreclosure," Allen Fishbein of the Consumer Federation of America said last week at a Senate hearing on nontraditional mortgages.
Who is most at risk? Exotic loans have been rising nationwide, but are most prevalent in states such as California, Nevada, and Florida where home prices have been rising fastest. They are far less common in the Northeast or Midwest.
And while buyers at all income levels have been tempted – option ARMs were originally targeted at the wealthy in the 1980s – experts say families with modest or low incomes may be most at risk.
"A significant percentage of people taking out interest-only mortgages and option ARMs have credit scores below the median and incomes at median or below," Mr. Fishbein said in his testimony.
The challenges don't begin and end with the negative amortization loans. Many borrowers with poor credit resort to so-called hybrid ARMs that also rely initially on below-market rates.
Payment shocks will land hardest not simply on the states with the most exotic mortgages, experts say. Other key factors will be the trajectory of the economy and of the inventory of homes for sale in specific markets. In a worst-case scenario, many homeowners would simultaneously face a spike in their monthly payment and a decline in their home's value, so that it's harder to resell.
Recent trends, including numbers out this week, suggest that home prices are beginning to decline nationwide. It's rare for such a pattern to persist, but economists also say this housing downturn appears to be getting worse than the last one in the early 1990s.
"It will take more than five years to get housing valuations back to where they ought to be," Merrill Lynch economist Sheryl King writes in a recent report.
Experts on both the pessimistic side, such as Ms. King, and the optimistic side agree on one thing: The impact of the ARM adjustments will occur over several years.
That, along with what Dr. Brown says is a very healthy banking system, could mitigate any broader economic impact.
"It's a time release," says Christopher Cagan, who did the risk analysis at First American Real Estate Solutions. "It's not a single impact like Pearl Harbor."