An article in the Washington Post this morning reminds us of a major headwind now coming back to the foreground over the next several months: mortgage resets. Fitch Ratings estimates that 70 percent of the $189 billion in outstanding option ARMs will reset to higher payments by 2011.

Option ARMs, also called pick-a-pay loans, allowed borrowers to choose how much to pay each month. Nearly all the borrowers who took out this type of loan from 2004 to 2007 chose to pay less than the interest due. Sometimes they paid as little as 1 percent interest. But the loans eventually require the borrowers to start paying the principal and full interest rate. This rate reset will cause monthly payments to increase an average of 63% over more than $1,053 a month. This type of cost increase will be effectively impossible to pay for the hundreds of thousands of homeowners who bought too much house at bubble prices. (Not too mention those who are now unemployed).

The most severe problems have surfaced in states with the steepest price drops. About 75 percent of option ARMs financed homes are in California, Florida, Nevada and Arizona, where prices have plunged on average 48 percent from the second quarter of 2006 to the first quarter of this year. Most of the effected people will be unable to refinance into lower rate payments because their houses are now worth much less than the loans.

The overall impact of the Option ARM resets should be less than from Subprime over the past 2 years, but the drag of still increasing housing supply and the negative knock-off effects of more families going under are going to continue to be felt in the economy for at least the next 2 years, maybe longer.

See: Another Wave of Foreclosures Loom