Over the last 60 years since World War II ended, a number of experimental loan programs have been attempted. These include interest-only loans, adjustable rate loans, and negative amortization loans among others. It is this group of loans that has consistently failed in the past for one simple reason: if payments can adjust higher, people will default. High default rates doom mortgage programs because these high default rates will eventually cause large default losses for the holders of these loans.

The Option ARM is certainly the most sophisticated loan ever developed. It is also a dismal failure, not because it lacks sophistication, but because it has embedded within it the possibility (near certainty) of an increasing payment. Any loan program that has the possibility of a higher future payment will fail because there will be a certain number of people who cannot afford the higher payment. Those who cannot afford their payment end up defaulting and the property goes into foreclosure.

Here is where the lenders delude themselves and deceive the general public after a financial debacle like the Savings and Loan problems of the 1980s or the Great Housing Bubble. They blame the collapse and the high default rates on some outside factor rather than the terms and conditions the lenders created all on their own.

There are still many out there who believe the high default rates and problems in the housing market in the 90s in California were caused by a weak economy. This is rubbish. House prices declined for 6 years. The decline started before the economy went soft, and it continued well after it had recovered. People defaulted because they overextended themselves on loans to buy overpriced housing, and toward the end of the mania, many were using interest-only loans.

Whenever lenders start loaning people money with total debt-to-income ratios over 36% people will default. Whenever lenders start loaning more than 80% of the purchase price, people can sink underwater and when they do, they will default. This is not new. It happened in the early 90s; it happened during the Great Housing Bubble, and it happened for the same reasons. Exotic loan programs always fail. It is only a matter of when and how disastrous the outcome is when it happens.