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Amherst Projects 'Awful' Option ARM Performance

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Defaults among pay-option adjustable-rate mortgages (ARMs) will continue to rise, especially as payment shocks still loom for loans set to recast in coming months [pictured below], but pricing of securities already reflects "simply awful" performance, according to the latest commentary from Amherst Securities Group. Option ARM defaults are likely to be high, as many borrowers began in a financially stressed position. About 90% of option ARM borrowers initially elected to make only the minimum monthly payment, Amherst said, which allows for negative amortization, whereby the difference between the interest accrual and the borrower's minimum monthly payment is tacked on to the principal balance. "It is important to realize that option ARMs were the ultimate affordability product, and borrowers who took them were a self-selected group," Amherst said in commentary this week. Negative equity represents a significant issue for option ARM borrowers, as it prevents refinance and makes modification difficult. But Amherst notes the key to performance is severity. "Putting together the high default rates with our expected severities and current market prices -- we conclude that better value can be found in the option ARM market than alternatives -- the subprime market or in the market for Alt-A hybrid floaters," Amherst says. Option ARMs in securitizations issued in 2006, so far experienced a 49% default rate, second only to subprime loans of the same time frame (61% defaulted). Alt-A loans follow at 39% defaulted, and prime loans finish out the categories at 11% defaulted. Option ARMs are no longer amortizing negatively, since the index used when the securities were issued has actually moved down considerably, while borrower payments rose. Interest-only payments are now above the amount needed to cover interest, so many loans are amortizing, despite the common misconception they're still in neg am mode. But option ARM borrowers are still in a bind. Option ARMs are difficult to modify, liquidation time lines differ greatly across servicers, and servicers are beginning to scale back on advances on high loan-to-value loans. Many option ARMs, for example, are worth more if liquidated than modified, Amherst said. HAMP mods, in particular, are designed to lower interest rates to bring borrowers within an affordable monthly payment. but the problem with option ARMs is the very nature of the product to bear low introductory rates, which are used to make monthly payments on relatively higher principal balances affordable in the short-term. Until recast, that is. As HousingWire already reported in a magazine issue, out now, around $134bn of option ARMs are set to recast over the next several years. Write to Diana Golobay.

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