When bad loans get worse

NEW YORK (CNNMoney.com) -- More than $1 trillion worth of adjustable rate mortgages (ARMs) will be hit with higher reset rates this year, and that could add up to big trouble for many homeowners.

Already, the rate of serious delinquencies among subprime hybrid ARM borrowers was up to 15.75 percent during the first quarter, from 14.44 percent in the fourth quarter of 2006, according to the Mortgage Bankers Association (MBA).

The end of the housing boom changed the math when it comes to ARMs. Not only are mortgage rates higher, but lower home prices in many markets means borrowers have fewer options than they had before home prices dropped.

Most hybrid ARMs - nicknamed "explosive ARMs" - are subprime products, but, according to Doug Duncan, MBA's chief economist, they can be useful tools for borrowers hoping to repair bad credit histories.

Credit-damaged home buyers could obtain a 2/28 hybrid ARM with affordable fixed-rate (teaser-rate) payments for two years before they reset at higher, floating rates.

At the end of two years, borrowers would ideally have made regular payments, demonstrated their credit-worthiness and raised their credit scores. They could then easily then refinance into an affordable fixed-rate loan.

Another kind of ARM borrower is the prosperous, low credit risk and financial savvy customer who chose the low initial interest rates on hybrid ARMs to free up cash for other purposes. When rates reset, they have the financial wherewithal to pay off loans or refinance into a fixed rate or another bargain-rate ARM.

But there is a third class of ARM users whose numbers grew during the most recent boom. They're the ones who chose ARMs because they couldn't finance their purchases any other way, and they gambled that soaring prices would make the deals work.

According to Peter Schiff, founder of Euro Pacific Capital (and a market "bear" of such notoriety, he's been dubbed "Doctor Doom,") many of those home buyers based their decisions solely on the affordability of teaser rates - and some even bought knowing they couldn't afford the teasers.

They figured, "All [home prices] had to do was go up 20 percent a year, and I'll be all right," Schiff said. If, six months into the loan, they found themselves strapped for cash, they could do a cash-out refinance to make their mortgage payments.

But before these borrowers reach their ARM reset points this year, a whole lot of things have gone wrong.

With the decline in home values over the past year and a half, many borrowers with resetting ARMs will have little or no equity in their homes.

Many bought with very small down payments of about 5 percent or less. In a market like San Diego, single-family houses fell 6.3 percent in value between September 2005 and March 2007, according to statistics from the Case Shiller home price index. And prices are likely to decline further through the year.

So anyone who bought in San Diego in 2005 with 5 percent down will actually owe more on the house than than its' worth.

Lenders are not too eager to refinance under conditions like that, so owners can get stuck paying the higher, reset mortgage payments. And interest rates have been on the rise, making those payments even worse.

Since many home-buyers overextended themselves to buy the home, they may find it impossible to keep up with higher payments, which could rise by $800 or so per month based on a 3 percent reset on a $380,000 loan.

Increased scrutiny from regulators has also resulted stricter underwriting standards, which can make it more difficult for high-risk borrowers to get loans of any kind.

The result: increased foreclosures and forced sales, flooding the market with homes and depressing prices even more.

"There will be a huge glut of houses that will be coming on to the market," said Schiff.

One ray of hope, according to Duncan, is that lenders increasingly recognize that it's cheaper to work with borrowers than to take over properties in falling markets. Repossessing a home costs a lender about a quarter of its value, making them more generous with loan work-outs than they were in the past.

Schiff, though, takes a characteristically apocalyptic stance on the future. Without the safety valve of home equity to tap, he says, an economy addicted to consumer spending will tank far more severely than anyone else expects. Home prices, he said, will plummet by half or more in some markets.

But even if much milder declines occur, some home owners are still in for a tough year.