One of the hottest financing products in the home purchase market -- so-called "option ARMs" -- could be reined in as the result of new actions on Wall Street and forthcoming guidelines for lenders from federal financial oversight agencies.

As of August 1, all new mortgage pools containing option ARMs rated by Standard & Poor's will carry the capital markets equivalent of a scarlet letter -- extra penalties in the form of tougher "credit enhancements."

Option ARMs have zoomed from a tiny niche product -- no more than 3 percent of new home loans in 2004 -- to 25 percent of all mortgage bond pools rated by Standard & Poor's in 2005.

Option ARMs are popular with home buyers -- especially in high-cost areas of California and along the Eastern seaboard -- because they enable consumers to cut their interest rates to as low as 1 percent for limited periods of time. Option ARMs give buyers a choice of several payment plans, ranging from minimum monthly payments (like a credit card), interest-only or fully-amortizing.

Borrowers who choose the minimum payment option are actually deferring interest payments to a later date. Their principal loan balance increases by the amount of deferred payments, a process known as negative amortization. Some option ARMs allow borrowers to rack up as much as 25 percent higher principal debt than their original loan amount.

For example, if they originally borrowed $400,000, they might be able to defer full payments until their principal loan balance hit $500,000. Option ARMs also contain periodic payment readjustments that can hit borrowers with severe monthly payment increases of 60 to 90 percent. Borrowers either have to come up with the required extra payment or find a new loan.

Wall Street, which provides the capital to fund option ARMs when they are pooled and securitized into mortgage bonds, is worried that too many home buyers using these loans have risky credit histories and are opting for the minimum payment plan without understanding the potential payment shocks ahead.

Standard and Poor's is the dominant rating agency in the multi-trillion-dollar "nonconforming" mortgage market that includes option ARMs. Its loan criteria set the rules for mortgage lenders who want to fund their loans through the global capital markets. When Standard & Poor's penalizes a particular type of loan -- considering it to be of higher than acceptable default risk for investors -- lenders tend to cut back on the number of such mortgages they make.

Standard & Poor's toughened its criteria on option ARMs made to borrowers with FICO credit scores at or below 695 -- a rising percentage of the overall option ARM market going to securitization. S&P's crackdown will not affect lenders who originate option ARMs for their own portfolios, some of whom restrict loans to borrowers with FICOs above 700.

"We wanted to jump in before this got any worse," said Standard & Poor's mortgage bond director Michael Stack.

Fitch Ratings, another major Wall Street agency, has also warned lenders about the high default potentials of option ARMs, arguing that the numbers of borrowers exposed to payment shocks in the coming two years is unacceptably high. Bond investors avoid mortgages with elevated probabilities of default because their pass-through payments of interest and principal are likely to be less.

Federal financial regulators are also taking hard looks at the risks posed by option ARMs, and are expected to caution lenders about them in forthcoming "guidance" expected by early Fall. Barbara Grunkemeyer, deputy Comptroller of the Currency and head of a multi-agency task force preparing the guidance, said he government has special concerns that option ARMs are being marketed in a "safe and sound manner" and that consumers understand the risks.

The net effect of the guidance, when issued, is likely to be to discourage lenders from extending them to credit-impaired buyers who can only afford the minimum payment, not the fully-amortizing payment.

The worst case scenario, according to Wall Street analysts, would be that large numbers of borrowers in high-cost but softening housing markets find themselves "upside down" thanks to negative amortization -- owing more to the lender than the resale market value of their property.