Certainly that is a possibility. That scenario is why I'd almost always go with a fixed mortgage. With ARMs you are gambling that we don't get run-away interest rates. I don't know how they determine the AAA ratings, but I personally feel that there are very few groups of ARMs that should be AAA. I have know idea how my standards and the banks' match up.
I am not sure if you know about the CMOs.... but here is a bad attempt to show you can have AAA paper...
You are looking at the 'whole' loan... and saying how can it be AAA... well, look at the one loan... say it is $100,000...
Well, I buy the first $10,000 of that loan... I get my interest FIRST, and my principal FIRST...
Someone else buys the next, say, $80,000... and gets his interest second and principal second...
And then the bank or someone else owns the last $10,000.....
SO, if the person stops paying... then nobody is being paid... but, I own the first $10,000 in principal whenever it starts to pay again... SO, we repo the house, have costs etc... the price goes down 40%.... well, they still have $60,000 to pay to the holder....
I get my $10,000 PLUS any unpaid interest... I am whole... do you not think this is pretty much AAA kind of paper?
Now.. the guy in the middle got (let's say) $40,000... so he got hit for 50% of his money plus lost interest....
The last guy wrote off his investment a few quarters ago... never expecting to get anything from this loan....