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Defaults on a popular form of mortgage that gave home buyers a choice of how much to pay each month are rising and could rival those on subprime loans, potentially causing more trouble for investors and banks.

Nearly $750 billion of option adjustable-rate mortgages, or option ARMs, were issued from 2004 to 2007, according to Inside Mortgage Finance, an industry publication. Rising delinquencies are creating fresh challenges for companies such as Bank of America Corp., J.P. Morgan Chase & Co. and Wells Fargo & Co. that acquired troubled option-ARM lenders.

Option ARMs typically were made to borrowers with higher credit scores than those getting subprime mortgages. But many of these borrowers were stretched thin even when they were making payments, and are particularly vulnerable to a weakening economy and falling home prices. Borrowers can face payment shock when they must begin making payments of full interest and principal.

Often, these loans were taken out without full documentation of borrowers’ incomes and assets, and the reported incomes were often overstated, analysts say. Option ARMs are concentrated in areas such as California and Florida that have seen some of the biggest home-price downturns.

Option ARMs, which have been largely abandoned, give borrowers multiple payment options, including a minimum payment that often was less than the monthly interest due. Borrowers who made the minimum payment on a regular basis often saw their loan balances grow, also known as “negative amortization.” And with home prices falling, more than 55% of borrowers with option ARMs owe more than their homes are valued at, according to J.P. Morgan Securities Inc. View full article »