The option adjustable rate mortgage (ARM) might be the riskiest and most complicated home loan product ever created. With its temptingly low minimum payments, the option ARM brought a whole new group of buyers into the housing market, extending the boom longer than it could have otherwise lasted, especially in the hottest markets. Suddenly, almost anyone could afford a home -- or so they thought. The option ARM's low payments are only temporary. And the less a borrower chooses to pay now, the more is tacked onto the balance.

The bill is coming due. Many of the option ARMs taken out in 2004 and 2005 are resetting at much higher payment schedules -- often to the astonishment of people who thought the low installments were fixed for at least five years. And because home prices have leveled off, borrowers can't count on rising equity to bail them out. What's more, steep penalties prevent them from refinancing. The most diligent home buyers asked enough questions to know that option ARMs can be fraught with risk. But others, caught up in real estate mania, ignored or failed to appreciate the risk.

...So how did these unusual loans get into the hands of so many ordinary folks? The sequence of events was orderly and even rational, at least within a flawed system. In the early years of the housing boom, falling interest rates made safe fixed-rate loans attractive to borrowers. As home prices soared, banks pushed adjustable-rate loans with lower initial payments. When those got too pricey, banks hawked loans that required only interest payments for the first few years. And then they flogged option ARMs -- not as financial-planning tools for the wealthy but as affordability tools for the masses. Banks tapped an army of unregulated mortgage brokers to do what needed to be done to keep the money flowing, even if it meant putting dangerous loans in the hands of people who couldn't handle or didn't understand the risk. And Wall Street greased the skids by taking on much of the new risk banks were creating.

A superb Business Week article on all things evil as regards ARMs (Adjustable Rate Mortgages). Middle-class folks are paying on ARMs, getting the cheap on interest in the short-term, and meanwhile they add back the deferred interest to their principle. This is called negative amortization. So, as their home values are plummeting in the after-boom bust market, their principal is rising.

Then there's negative-amortization accounting, which pro-Austrian James Grant calls, "a fraudulent gambit. But what it lacks in morality, it compensates for in ingenuity." James is right because lenders can accrue, as revenues, the fully amortized amount of the option ARM, even though borrowers are making their minimum payment. This appears to be a sort of phantom revenues because the risk aspect is such that the revenue may never be fully realized. This is why opponents of this methodology - such as Grant - see it as fraudulent accounting. But FASB (Financial Accounting Standards Board), the overseer of GAAP, told Business Week that it is "concerned that the disclosures associated with these types of loans [are] not providing enough transparency relative to their associated risks." I call it "contrivance accounting," wherein a bit of finesse is applied to the rules in order to make them applicable to the particulars of time and place.

The worst solution is to commingle the private and public sector, as the SEC has been doing concerning FASB. The Financial Accounting Standards Board has been moving away from rules-based standards toward standards that are principles-based, and however good this is, it also entails more government oversight, as the SEC has noted. Thus a reason for the SEC to stomp on private bodies that oversee the accounting profession.

One lender, Washington Mutual, had $2.5 billion in loans being negatively amortized as of 2005, and this year? $12 billion. Washington Mutual's spokesperson cited full compliance with GAAP (Generally Accepted Accounting Principles). Some analysts say that these banks are not going to be in much financial trouble, due to the clever ways in which they manage risk and protect their portfolios. I don't necessarily agree, especially knowing that the real asset collateral is spiraling downward in value, putting the industry at risk for a real estate fallout that could far exceed the S&L debacle of times past.