Why Mortgages Blew Up

Many homebuyers in recent years took out exotic mortgages that ultimately backfired. This raises the question of why such booby-trapped financing was available at all.

The answer, in part, stems from overaggressive marketing of what were once niche products intended only for the most financially sophisticated and creditworthy customers. During the housing boom in recent years, banks began offering such elaborate loans to huge numbers of average homebuyers, allowing them to get in over their heads and contributing to the current mortgage crisis, as many borrowers ended up defaulting.

Last week, TheStreet.com reported that several of nation's largest lenders, such as Countrywide Financial(CFC Quote), were still offering the types of loans at the center of the current meltdown in the subprime mortgage market. That's despite the fact that the company has taken a beating on the stock price, down about 40% over the past month, and some of the loans offered seem doomed to fail from the outset.

The most exotic product, the option ARM (adjustable-rate mortgage), or negative amortization loan, allows the borrower the choice of paying a minimum amount that might not even cover the interest on the loan.

If that alternative is taken, the shortfall is added to the loan balance, and so the borrower gets further and further into debt over time. Such loans are inherently risky for the debtor and the lender as well. Another risky type of loan is the interest-only mortgage. The balance on an interest-only loan doesn't increase over time, but it doesn't decrease either. The borrower is essentially just treading water.