Foreclosures will rise over the next few years, experts agree. While each foreclosure is traumatic for the family that loses a house, the coming wave of defaults won't swamp the system.

The borrowers who are in the most danger have two strikes against them. First, they are (or will be) underwater -- owing more than the house is worth. Second, they have adjustable-rate mortgages, or ARMs, with low "teaser rates." Eventually, after anywhere from one month to five years, the ARM enters its rate-adjustment period and the loan is reset with a higher rate.

Quite a few homeowners have these two strikes against them, and almost $200 billion in foreclosures will result, says Christopher Cagan, director of research and analytics for First American Real Estate Solutions.

Cagan prepared a 32-page report (PDF) in February that measured the extent of the risk to the mortgage market. It's not a financial-planning guide, but here's what consumers can take away from it: If you have an ARM with a teaser rate of 2.5 percent or less, watch out, because the monthly payments could skyrocket -- even double -- after the rate is reset. And if, in addition, you owe more than the house is worth, you could find yourself in serious trouble -- unable to refinance and unable to sell without a loss.

Pretty common-sensical, really. That's why Larry Goldstone isn't all that worried.

'People are good people'
Goldstone, president of Santa Fe, N.M.-based Thornburg Mortgage, says, "Generally speaking, I think people are good people. They borrow money with the intention of paying it back."

When the business cycle moves down and people lose their jobs, more of them default, Goldstone says; it doesn't matter much if the borrower gets a 30-year, fixed-rate mortgage or something nontraditional, such as a payment-option ARM, in which the minimum payment doesn't even cover that month's interest.

David Greco, vice president of credit policy for MGIC, the largest insurer of mortgages, agrees that the loan type doesn't matter much. A precarious mortgage, he says, is one "where the likelihood that they'll be able to repay it is low, and I don't think there is anything that is inherently risky about any loan programs that are out there today."

Accurate assessment vital
The risk comes from the possibility that the borrower and lender didn't accurately assess the borrower's ability to repay, Greco says. One person might be able to handle a payment-option ARM with aplomb, while another person might wilt under a 30-year fixed.

That's not exactly how the federal government sees it. Regulators have proposed guidance -- essentially, a set of strong suggestions -- urging lenders to be more careful with interest-only and payment-option ARMs, especially in cases where the homeowner has little or no equity in the house or when the borrower produced little or no documentation of income and assets.

"The Agencies are also concerned that these products and practices are being offered to a wider spectrum of borrowers, including some who may not otherwise qualify for traditional fixed-rate or other adjustable-rate mortgage loans, and who may not fully understand the associated risks," the proposed guidance says.

Bankers worry that the guidance could result in fewer loans to deserving home buyers. "The question is, without these products, would we be better off? The answer is no," says David Herpers, chief marketing officer for Amerisave, a lender that specializes in customers with damaged credit. "I think, as a consumer, these emerging mortgage products are, overall, extremely beneficial."

Anthony LaGiglia, a financial planner with J.J. Burns & Co. in Melville, N.Y., isn't as sanguine about nontraditional mortgages. "When you look at interest-only mortgages, they were for a very select group of people -- a business owner or a Wall Street person who gets a huge bonus every year," he says. "But they're becoming more commonplace. A lot of people are utilizing them just to afford a house. A lot of people are getting in over their heads."

He wonders what will happen to people who got low-rate ARMs when the rates enter the adjustment period and rise dramatically. "I think people have no idea what can happen when the loans reset at higher rates," he says. "People say, 'Oh, I'll refinance in the future.' But we've been at 30-year- and 40-year-low interest rates!"

That brings us back to Cagan, who wrote the paper for First American about reset sensitivity -- what will happen when borrowers' payments spike after ARMs hit their adjustment periods. He says there will be an extraordinarily high default rate among people who got teaser-rate option ARMs and who have less than 15 percent equity in their homes. But those people are a small part of the overall pool of homeowners.

"Nationally, I think it will be a common cold, if you will," Cagan says, while acknowledging that it will feel much worse to the people who lose their homes to foreclosure.

"The people who bought in 2003 or sooner ... they generally have enough equity that they're going to do all right," Cagan says.

ARM debt and 'reset sensitivity'

Christopher Cagan, director of research and analytics for First American Real Estate Solutions, estimates that ARMs account for almost 40 percent of mortgages that were originated in 2004 and 2005, accounting for $1.9 trillion in ARM debt. Of those loans, about $431 billion started out with rates at 2.5 percent or less. The borrowers with those loans have the highest risk of not being able to make their payments when the rate adjustment arrives, because their rates could double, or come close to doubling, in a short period. He assumes that a lot of these mortgages are payment-option ARMs. Since a minimum payment   doesn't even cover the interest accrued that month, the balances on these loans can rise to 15 percent or 20 percent above the original balance. That in itself can endanger borrowers. According to Cagan's calculations, 51 percent of these borrowers have less than 15 percent equity in their homes. They could end up in double trouble: unable to make their minimum monthly payments after the loan rate adjusts, while owing more than the house is worth. Of this riskiest group -- people who have less than 15 percent equity in their homes, and who got ARMs with teaser rates of 2.5 percent or less, Cagan estimates that 90 percent could default, resulting in $198 billion in foreclosures over several years. The loss to lenders and investors will be less than half that, after they sell the foreclosed-on homes. That's a lot of money. But when you consider that the nation's residential real estate is worth more than $19 trillion, and homeowners have more than $8 trillion in mortgage debt, it's a problem that can be managed.