'Pay option' loans could swell defaults

New wave of defaults likely as risky loans reset to sharply higher payments
By John W. Schoen
Senior producer
updated 9:01 p.m. ET, Wed., Dec. 10, 2008

Some time after Sharren McGarry went to work as a mortgage consultant at Wachovia’s Stuart, Fla., branch in July 2007, she and her colleagues were directed to market a mortgage called the “Pick A Pay” loan. Sales commissions on the product were double the rates for conventional mortgages, and she was required to make sure nearly half the loans she sold were "Pick A Pay," she said.

These “pay option” adjustable-rate mortgages gave borrowers a choice of payments each month. They also carried a feature that came as a nasty surprise to some borrowers, called "negative amortization." If the homeowner opted to pay less than the full monthly amount, the difference was tacked onto the principal. When the loan automatically “recasted” in five or 10 years, the owner would be locked into a new, much higher, set monthly payment.

While McGarry balked at selling these pay-option ARMs, other lenders and mortgage brokers were happy to sell the loans and pocket the higher commissions.

Now, as the housing recession deepens, a coming wave of payment shocks threatens to bring another surge in defaults and foreclosures as these mortgages “recast” to higher monthly payments over the next two years.

“The next wave (of foreclosures) is coming next year and in 2010, and that is primarily due to these pay-option ARMS and the five-year, adjustable-rate hybrid ARMS that are coming up for reset,” said William Longbrake, retired vice chairman of Washington Mutual. The giant Seattle-based bank, which collapsed this year under the weight of its bad mortgage loans, was one of the biggest originators of pay-option ARMs during the lending boom.