Option-ARMs are those exotic mortgages where the mortgagee gets to decide how much to pay off. If he doesn't pay at least interest, then the balance gets added onto the principal and he goes into a "reverse mortgage" where he is actually borrowing more over time instead of paying back, UP TO SOME LIMIT, at which time the bank will insist on a minimum monthly payment.
Apparently they were popular in California, where real estate prices had so far outstripped incomes that it was probably the only way many people thought they could afford a house.
http://www.economist.com/finance/displaystory.cfm?story_id=11921871...roughly 1.4m households, most of them in California, hold a particularly nasty type of adjustable-rate mortgage called the “option ARM”. Although the overall value of option ARMs is lower than that of subprime loans—some $500 billion, according to Mr Strand, compared with about $1 trillion in subprime loans—their sting is more venomous.
...
Delinquencies are already rising fast. Write-offs for option ARMs at Washington Mutual, a stumbling thrift, have zoomed from 0.49% in the last quarter of 2007 to 3.91% in the second quarter. But the real crunch will come when the mortgages “recast”, forcing borrowers to start making full payments. The loans recast after a set period (typically some five years after origination) or when the principal hits a predetermined ceiling. The biggest wave of recasts is due to happen in 2010 and 2011. By some estimates, borrowers’ monthly payments will then surge by 60-80% (see chart), at a time when property values may still be at, or close to, their trough.
Emphasis mine
So, between now and some time between 2010 and 2011, there is going to be a HUGE number of defaults in California. I would guess that...
* If Washington Mutual is not insolvent by then it will be.
* Given the number of houses we are talking about, it seems unlikely that the housing bust will be entirely over before then. So probably about 2 more years of pain?
* If the Fed responds by monetizing debt, then assume that much more "ammunition". "Monetizing debt" means creating credit "out of thin air" to buy up the bad debt; this is considered massively inflationary, because you have all this new money, but not all these new goods and services to show for it.
It is also worth noting that California has a state government deficit crisis brewing, and Gov. Schwarzenegger still has not found a way to control it.
