The great walkaway to come in California

Former Curious Capitalist guest blogger Mark Gimein has a nice scaremongering piece in Slate (or is it on Slate? At Slate?) about the next mortgage shoe to drop: affluent Californians with option ARMs.

The most common subprime loans were known as "2/28" in the industry: 30 years, including a two-year teaser rate before the interest rate rose. Now these loans have reset, and we're seeing the fallout.

But prime borrowers, too, got loans that started out with low payments; if you bought or refinanced your house in the last few years, it's not unlikely that you have one. With an "option ARM" loan you have the "option" (which most borrowers happily take) of paying less than the interest; the magic of "negative amortization." The loan grows until you hit a specified point—the exact point varies with the lender; with Countrywide, it'll come after about four and a half years—when the payment resets to close to twice where it was on Day 1.

Just two banks, Washington Mutual and Countrywide, wrote more than $300 billion worth of option ARMs in the three years from 2005 to 2007, concentrated in California. Others—IndyMac, Golden West (the creator of the option ARM, and now a part of Wachovia)—wrote many billions more. The really amazing thing is that the meltdown in California is already happening and virtually none of these loans have yet reset.

Mark's argument is that as these option ARMs reset, lots of borrowers in the Golden State will take a look at what they owe and at what their houses are actually worth now (26% less than they were a year ago) and simply walk away.

My general feeling is that the lenders who made these loans deserve that kind of treatment. Until a decade or so ago, the most straightforward and reliable measure of whether you could afford a house was whether somebody would lend you enough money to buy it. American homebuyers had come to rely on that. It was what you could call a pretty danged good heuristic. And mortgage lenders went and totally invalidated it.

But of course, if California borrowers start walking away from their option ARMs en masse, then house prices there go down even more and our financial mess gets worse.