Lenders and government officials are searching for ways to head off a wave of defaults on pay-option adjustable rate mortgages, which are threatening to become the next storm to hit the U.S. housing market.

Option ARMs aren't easy to modify due to the risky features of the loans and their concentration in states where property values have plummeted the most. The loans catered to creditworthy borrowers who had to stretch a great deal to buy a home in an overheated market.

Option ARMs allow borrowers to choose from a range of minimum monthly payments, including paying less than the interest owed each month. Many such borrowers are now grappling with ballooning loan balances and plunging property values.

Administration officials have been talking to mortgage investors and servicers about ways to help option ARM borrowers avoid foreclosure, but the parties don't appear close to a solution. A major sticking point: Whether lenders need to forgive loan principal to help these borrowers stay in their homes.

"All sides are talking," said Laurie Goodman, a senior managing director of broker/dealer Amherst Securities Group. "The servicers and investors have different solutions to the problem. Servicers are more reluctant than investors to forgive principal."

Mortgage investors contend that forgiving loan principal is crucial because so many option ARM borrowers are underwater, owing much more than their homes are worth. Meanwhile, servicers favor taking other measures before writing off any loan principal. The government risks a backlash from borrowers who are paying off their loans in full if it takes steps to encourage principal forgiveness.

A U.S. Treasury Department spokeswoman declined to comment.

The major mortgage servicers - JPMorgan Chase & Co. (JPM), Wells Fargo & Co. (WFC) and Bank of America Corp. (BAC) - also hold large portfolios of option ARMs acquired through purchases of other banks. Investors suspect that they are reluctant to forgive principal on option ARMs in their servicing portfolios because that could trigger write downs of the banks' option ARM holdings.

Delinquencies and foreclosures of option ARMs are climbing and the problem is expected to get worse. In the second quarter, 15.2% of option ARMs were at least 60 days past due, compared with a 5.3% delinquency rate for all mortgages, the Office of the Comptroller of the Currency said in a report analyzing 34 million U.S. mortgages. Meanwhile, 10% of option ARMs were in the process of foreclosure, more than triple the 2.9% rate for all mortgages, the OCC said.

The poor performance partly reflects the loans' heavy concentration in the four states that have seen the sharpest price drops. Option ARMs represent nearly 40% of loans at least 60 days past due in Florida and in Nevada and 28% of such loans in California, according to First American CoreLogic. One in five delinquent mortgages in Arizona is an option ARM.

Making matters worse, more than a million option ARMs are due to reset over the next four years, according to First American CoreLogic. When that happens, borrowers who were making partial interest payments will have to make fully amortizing payments reflecting a larger loan balance.

Option ARMs aren't good candidates for the government's loan-modification program. Borrowers with such loans are often already struggling to make already very low payments, leaving little room to cut the payments further.

Some borrowers are so deeply underwater that lenders would have to write off or defer huge amounts of loan principal to achieve a sustainable modification. That could trigger a failure of the net present value test required to complete a modification under the government's program.

Mortgage servicers are seeking changes to the program to make it work better for option ARMS. They propose forgiving deferred interest, converting the loan to one with an interest-only period and increasing the loan term before any principal is written off. By contrast, investors favor refinancing borrowers who qualify into a Federal Housing Administration-backed mortgage after the loan principal has been cut.

Wells Fargo, which values the Pick-A-Pay loans it acquired when it bought Wachovia Corp. at $90.45 billion, isn't modifying these loans through the government's program.

Mike Heid, co-president of Wells Fargo's Home Mortgage business, told Dow Jones it was difficult to modify Pick-A-Pay mortgages through the government's program. The bank has modified 60,000 Pick-A-Pays through its own programs.

Investors argue that slashing monthly payments or forbearing principal - when portions of the loan balance is deferred - won't help many option ARM borrowers because they are so upside down on their mortgages.

The concern with principal forbearance is that people may still owe much more than their house is worth, argued Michael Henriques of Magnetar Capital, a mortgage investor. "There's no material incentive to maintain or take care of it," he said. That deterioration drags down the property values of the neighboring houses as well, prolonging the housing recovery, Henriques added.

Spokesmen for Bank of America and JPMorgan declined to comment.

Bank of America valued the pay-option loans it acquired when it bought Countrywide Financial Corp. at $23.2 billion as of December 31, 2008. Meanwhile, JPMorgan holds nearly $40 billion of option ARMs from its acquisition of Washington Mutual last year.

-By Jessica Holzer, Dow Jones Newswires; 202-862-9228; jessica.holzer@dowjones.com