Payment option adjustable rate mortgages are about to go through major resets, sending federal and state regulators scurrying to withstand a new wave of defaults and foreclosures. The impending changes were a major topic of conversation when the state magistrates met with Obama administration officials to discuss strategies for combating mortgage fraud. “Payment option ARMs are about to explode,” Iowa Attorney General Tom Miller told Reuters after that meeting. The loans — which give borrowers the option of making small interest-only payments each month, leading to an increasing principal balance — have left many homeowners underwater in their mortgages. The problem is compounded when the loans reset, meaning monthly payments must rise to begin paying down the full balance. Introductory interest rates may also reset to higher levels. All those factors can lead to a bevy of new troubled borrowers, experts say. In Arizona — one of the states hardest hit by the mortgage crisis — 128,000 option ARMs will reset in the next year, State Attorney General Terry Goddard told Reuters.

The San Francisco-based mortgage consultant Loan Performance has estimated that 469,000 option ARMs were issued in the U.S. between 2000 and 2007, when most lenders halted the practice. That means hundreds of thousands of borrowers will be on the hook for payments of 5 to 10 times more than the usual mortgage payment, obligations that will “threaten a much greater hit to the consumer than the subprimes,” Goddard said. One researcher’s work shows how bad the option ARM effect could be on the economy. Joseph Mason, a banking professor at Louisiana State University, estimates that 75 percent of option ARM holders made minimum payments for as many as five years, failing to refinance or buy down principal balances. “The only ones left in the product now are those who couldn’t afford something else when they got the loan,” Mr. Mason told the New York Times. “Now all they can likely afford is the minimum payment, so they’re just buying time in a dwelling until their reset date.” Despite positive signs of a housing recovery — increasing home prices and sales in most markets nationwide — foreclosures have been continuing to rise, even before option ARMs became an area of concern. According to the data service RealtyTrac, one in every 357 homes in the U.S. had a foreclosure filing in August. The option ARM “time bomb” threatens to deepen the foreclosure hole, adding to inventories of abandoned or unsold homes and squeezing the industry’s fragile valuation gains. “It’s the other shoe,” Goddard said. “I can’t say it’s waiting to drop. It’s dropping now.”