Interest-only and negative amortization payments cannot go on forever. At some point, the loan balance must be paid in full. For all adjustable rate mortgages, there is a mandatory recast after a fixed period of time where the loan reverts to a conventionally amortizing loan to be paid over the remaining portion of a 30 year term.
A recast is not the same as an interest-rate reset. A reset is a change in the interest rate being charged on a particular loan. The amount of the payment may go up or down (although it usually goes up) when a reset occurs. A recast is a change in payment necessitated by a change in the amortization method. This recast eliminates the options for negative amortization and interest-only payments and requires the fully amortized payments on an accelerated schedule for what is often an increased loan balance. The payment after a recast is always higher.
For instance, if an interest-only loan is fixed for 5 years, at the end of 5 years, the loan changes to a fully-amortized loan with payments based on the remaining 25 year period. The longer interest-only or negative amortization is allowed to go on, the more severe the payment shock is when the loan is recast to fully amortizing status. Also, in the case of negative amortization loans, the total loan balance is capped at a certain percentage of the original loan amount, typically 110% but sometimes higher. If this threshold is reached before the mandatory time limit, the loan is also recast as a conventionally amortizing loan. Since many borrowers were qualified based on their ability to make the minimum payment at the teaser rate, when the loan recasts and the payment significantly increases (double or triples or more,) the borrower is left unable to make the payment, and the loan quickly goes into default.
The natural question to ask is, "Why would lenders do this?" There is no easy answer. Most simply did not care. The lender made large fees through the origination of the loan and subsequent servicing, and the loan itself was sold to an investor. The investor bought insurance against default, and many of these loans were packaged into asset backed securities which were highly rated by ratings agencies due to their low historic default rates. Nobody cared to examine the systemic risk likely to result in extremely high future default rates because the business was so profitable at the time of origination. Most assumed this would go on forever as house prices continued to appreciate. It was envisioned that most borrowers would either increase their incomes enough to afford these payments or simply refinance into another highly profitable Option ARM loan.
In hindsight, the folly is easy to identify, but for those involved in the game during the Great Housing Bubble, there was little incentive to question the workings of system, particularly since it was so profitable to everyone involved.