The next sub-prime mortgage crisis
The American economy is braced for a new wave of mortgage defaults says Euan Stuart
A fresh wave of mortgage problems is threatening to engulf the US economy: option adjustable-rate mortgages, or option ARMs. Option ARMs, which make up 25 per cent of the US mortgage market, offer a low initial rate which re-sets to a higher market rate after a fixed period of time, usually five years. They are popular with low-income buyers who can put off their payments until salary increases come through or the rising housing market (remember?) pushes up the value of their property.
However, the shortfall in the initial payments is then added to the mortgage, so that when the higher repayments begin they are even more painful than they would otherwise have been. That's not the only problem. This option to borrow more initially and add it to the total debt, known as 'negative amortisation', is limited, so that if the ceiling (usually 110-125 per cent 
of the original loan) is reached, then the higher payments can kick in early.
And as if that wasn't enough, there are severe penalties to prevent mortgage holders re-financing to take advantage of cheaper deals elsewhere.
Now the day of reckoning is drawing near. Option ARMs issued across the US in 2004 reset next year at the end of their five-year lifespan. It is estimated that there is an outstanding total of $200bn of such loans in the US and that over the next two years almost half of that, $96bn, will be reverting to higher rates, raising borrowing costs and increasing the likelihood of defaults.
According to ratings agency Fitch, this could more than double the number of borrowers currently falling behind on their payments, a figure already running as high as 24 per cent in some areas.
More than half of these mortgages are with subprime borrowers, meaning the slump is set to worsen in some of the areas already most affected by the housing crisis (although upmarket neighbourhoods will not be immune
since these products were also popular with better-off buyers who assumed that prices would carry on rising forever).
And that's not all. There is every likelihood of this debacle developing into a full-blown financial scandal, just as in the UK when missold endowment plans issued in the 1980s came back and bit the mortgage firms. Salespeople were paid more to sell option ARMs than normal mortgages, in many cases to customers with little or no financial knowledge.
The attractiveness of these deeply-flawed products to both sellers and buyers meant that in some areas of the US as much as 50 per cent of the mortgages taken out were option ARMs. Will Hank Paulson's bail-out be big enough to deal with this new problem? We shall see. 
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