The Explaineology of "Neutron Loans"

Feb. 7 (Bloomberg) — Joe Ripplinger took out a $184,000 mortgage in 2006 and makes his payments every month.

Now he owes $192,000.

The 66-year-old Minneapolis house painter has a payment-option adjustable-rate mortgage. It allows him to write a check for $565 a month even though he owes $1,300. The difference is added to the mortgage, and when his total debt reaches $212,000, or after five years have passed, he said his monthly minimum could jump to about $2,800, which he can’t afford.

“We’re barely making it right now,” Ripplinger said.

The estimated 1 million homeowners with $500 billion of option ARMs are beyond the help of interest-rate cuts by Federal Reserve Chairman Ben S. Bernanke. While subprime borrowers face an average increase of 8 percent or less when their adjustable- rate mortgages reset, option ARM homeowners may see their monthly payments double after their adjustments kick in.

“We call them neutron loans because they’re like a neutron bomb,” said Brock Davis, a broker with U.S. Express Mortgage Corp. in Las Vegas. “Three years later the house is still there and the people are gone.”

Once option ARM borrowers’ loan balances reach a predetermined limit, called a negative amortization cap, usually 110 percent to 120 percent of the mortgage amount, their payment rates immediately increase. They also automatically shoot up after five years. Otherwise, increases typically are capped at 7.5 percent of a borrower’s initial payment per year.

One in Five

“These could be called long-fuse, exploding ARMs,” said Kathleen Keest, former assistant Iowa attorney general and now senior policy counsel at the Center for Responsible Lending in Durham, North Carolina. “I’ve heard people say they are the most complicated product ever offered to consumers. They are the real liar loans.”

The loans accounted for 8.9 percent of the almost $3 trillion in U.S. home loans made in 2006, up from 8.3 percent in 2005, according to an estimate by industry newsletter Inside Mortgage Finance. Originations of option ARMs fell 50 percent during the first nine months of last year, the newsletter says.

One in five option ARMs packaged into bonds last year required less than 10 percent down payment and no proof of a borrower’s income, according to a Jan. 22 report by New York- based analysts at UBS AG, Europe’s largest bank by assets. Two percent required no down payment at all from the borrower, the analysts said.

Better Scrutiny

Delinquency rates on option ARMs tend to be low in the early years, misleading some investors to think they will remain safe, said Sean Kirk, a debt trader at Seaport Group LLC, a New York- based securities firm focused on bonds of distressed or restructured companies.

Four types of home buyers typically get option ARMs.

Speculators, who plan to sell the property quickly, made up 12 percent of all option ARMs packaged into bonds last year, according to UBS. That included only borrowers who identified themselves as investors and not residents, who get lower mortgage rates. Wealthy people have used the loan for its flexibility, according to Thornburg Mortgage Inc. in Santa Fe, New Mexico.