Do Consumers Understand Nuances of Option-Payment ARMs?

Washington -- Federal regulators appear to be scared that option-payment ARMs are going to blow up in the next few years and borrowers could get burned, especially if the economy goes into recession.

As option adjustable-rate mortgages become mainstream loan products, the regulators are seeing underwriting standards slip along with low documentation of borrowers' income and piggyback loans to lower the downpayment and avoid mortgage insurance.

As Office of the Comptroller of the Currency, Federal Reserve Board and Federal Deposit Insurance Corp. officials draft guidance on interest-only and option ARMs, they are concerned about this layering of risks, as well as mortgage and appraisal fraud.

But they are also beginning to wonder and worry if consumers understand these loans and what the lenders are telling them.

Deputy comptroller Barbara Grunkemeyer told risk managers at a conference last week that type of IO and option ARMs originated in past few years has not been tested in a recession.

She cited a recent report by UBS Securities that shows 70%-80% of option ARM borrowers are taking the minimum payment option. These borrowers, due to negative amortization and higher interest rates, could see their monthly mortgage payments increase by 50% when these mortgages reset.

"They are going to remember that you did not explain to them that the payments were going to go up 50% after five years. And now they can't pay it," Ms. Grunkemeyer said.