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For three months running, government data shows that adjustable rate mortgages, also known as Option ARMs, have supplanted sub-prime mortgages as the biggest driver of home foreclosures. Why option ARMS – and what can ARM consumers do to get out of their mortgages?

Option ARM mortgage-holders know the stakes (or the should now, considering the increasingly alarming media attention focusing on ARMs). In a word, option ARMs allow mortgage holders to pay their monthly bank note on a tiered platform, including a low, partial-interest payment. The big risk is that by paying only a portion of the interest (and little on the principle) home mortgage balances can rise instead of fall.

That’s not a good idea at a time when home values are plummeting. At some point the rising mortgage balance and the falling home values cross paths, and after that, homeowners can owe more on their houses than the homes are worth. In mortgage parlance, those homeowners become “underwater”.

How bad is it out there? According to monthly data from First American CoreLogic, which tracks ARM payments, 36.9% of Option ARMs were delinquent in April, 2009. The same month, 19% of Option ARMs collapsed into foreclosure. Compare that to October, 2005, when only 0.04% of Option ARMs were foreclosed, and March, 2006, when only 0.49% of Option ARMs were 60 days late in mortgage payments.

Or, more recently, only 8% of Option ARMS were in foreclosure only one year before, in April of 2008. And only 15.7% lapsed into delinquency, First American reports.

The ramifications of souring Option ARMs will reverberate throughout the already ailing real estate market. First, foreclosures in hard hit areas like California, Florida, and Nevada, will slam home values in those states, just at a point when many real estate analysts were beginning to see signs of stabilization in local home prices. Foreclosures are notorious for dragging a community’s average housing value down.

Banks will take a hit, too. Sooner or later, financial institutions will have to come to grips with the billions they’ve taken on in Option ARM loans. Washington Mutual, swallowed up last year by JP Morgan Chase (Stock Quote: JPM), had $57 billion worth of Option ARM loans in June, 2008, the time that the bank decided to get out of the Option ARM business.

If you do the math, and hypothetically figure that Chase has almost 20% of its ARM holders in foreclosure (based on the monthly First American numbers), the bank is looking at a loss of almost $10 billion in toxic ARM loans, with more coming down the pike. Wells Fargo (Stock Quote: WFC) also has a big stake in the Option ARMs market, and may also be recording their mortgage balance sheets in red ink rather than black. It recently absorbed Wachovia (Stock Quote: WB), which had absorbed Golden West – one of the huge underwriters of “alternative” mortgage products like adjustable-rate mortgages.

What’s an ARM holder to do? For starters, check with your bank and find out when the reset date kicks in. That way you can plan for your mortgage rate going up (or down) based on the direction of interest rates. The one silver lining this year is that interest rates have stayed relatively low, thanks to the Federal Reserve’s policy of clamping down on interest rates in an effort to keep money flowing in the credit market.

If you have an adjustable rate mortgage, and have some equity on your home, refinancing is a great option. Banks increasingly want ARM loans off the books, and are more receptive (for banks, anyway) to getting you into a traditional 30-year fixed-rate loan.

There’s little doubt among bank analysts that Option ARMs represent the second big wave (after sub-prime mortgages) that threaten the U.S. real estate market, and the economy with it.

If so, Option ARMs will take their rightful, if notorious, place in future economic textbooks – most likely in the section labeled “Stupid Mortgage Loan Tricks.”

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