Performance on U.S. option ARM RMBS is probably going to continue its drop as $134  billion  of  these  loans  will  recast  over  the next two years, Fitch Ratings said in a report released today.

Of  the  $189 billion securitized option ARM loans outstanding, 88% have still  to  experience a recast event, even though it should be noted that Fitch rated  only  roughly 5% of option ARM transactions.

Of these loans that  have not yet recast, 94% have used the minimum monthly payment
to  allow  their  loans to negatively amortize.

"Having not demonstrated their  ability  to  make payments at the full rate, option ARM borrowers
 are  at the greatest risk of default resulting from payment shock,’ said Group Managing Director and U.S. RMBS group head Huxley Somerville.

More evidence of option ARM underperformance in the last year lies in the number of outstanding securitized option ARMs either 90 days or more delinquent,  in  foreclosure or REO proceedings, which has risen  from  16%  to  37%. 

Total 30+ day delinquencies are now 46%, despite the fact that only 12% have recast and experienced an associated payment  shock.  Instead,  negative and declining equity has presented a larger  problem:  due to high concentrations in California, Florida, and other  states  with rapidly declining home prices, average LTV ratios  have  increased from 79% at origination to 126% today.

"Negative equity  and  payment  shocks will continue as Option ARM loans recast in large numbers in the coming years," Somerville said.

Option  ARM loans have been a concern for some time specifically because of  negative  amortization.  This feature allows for the loan balance is able  to  grow over time; typically to a balance cap of 110% to 125% of the original mortgage. In an event known as ‘Recast’, once the loan hits the balance  cap or reaches 60 months in age, the borrower’s monthly payment
obligation  increases  from  a  minimum  monthly  payment   to  a  fully amortizing  P&I payment.

This fully amortizing P&I payment is on average 63%  higher  than the MMP, and can be more than double depending on loan attributes   and   interest   rate   behavior. 

These  concerns  at  the securitization  issuance  are  largely  what  drove Fitch to rate such a small number of option ARM transactions.

To  date,  3.5%  of  the  roughly  one  million  2004 to 2007 vintage securitized option  ARM  loans  have  been  modified,  in an attempt to mitigate  effects  from  the  payment  shock. 

Modification  types  have included  term  extension,  conversion  to interest only loans, interest rate   cuts,   and   others.  These  modifications  have  been  somewhat successful,  with  24%  of  modified  option  ARM  loans  being 90+ days delinquent,  compared  with  37%  of  the  overall option ARM universe.

However,  because this product features lower MMP payments than would be available  after  recast, even with substantially favorable modification terms,  there  may  still  be  material  payment shock. Thus, Fitch expects a high default percentage for modified option ARM loans.

Generally, Fitch’s  expected  losses for recent-vintage option ARMs range between  roughly  35% to 45%,  depending on the collateral quality of the  underlying  mortgage  loans. 

Aside from expectations of higher defaults,  severities  have also contributed to higher expected lifetime losses. 

Fitch  has  observed  that  loss severities on option ARMs have rose considerably  to  an average of roughly 60% from 40% a year  ago. A key driver in the worsening severities is the fact that 75% of  option  ARM  loans  are  secured  by  properties located in California, Florida, Nevada, and Arizona, which have experienced average dips  of  48% from second quarter-2006 to date.

Even without further declines  in  home  values, defaults on option ARM loans are expected to
soar as loan recasts occur, as these borrowers are unable to effectively refinance into alternative mortgage product.

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