More than $200bn of outstanding pay-option adjustable-rate mortgages (ARMs) originated and securitized from ’04-’07, according to market commentary by Moody’s Investors Service this week. This sector shows “dismal” performance, with more than 40% of borrowers 60 or more days past due on payments. And many of these loans have yet to experience a recast event, when initial minimum monthly payments jump as much as 60%, according to sources interviewed by HousingWire for an upcoming issue. “Even though borrowers with Option ARM loans have the option to make monthly payments typically lower than the accruing interest on the loan, many borrowers are choosing a different option–not making any payment at all.” Moody’s said the performance is comparable to subprime, despite the trend of more acute negative equity among Option ARMs than subprime. Negative equity is a key driver of weak performance — as well as a more predictive measure of default than unemployment — particularly among Option ARMs. Modifications would have to be applied aggressively to have any lasting effect and keep borrowers paying on their mortgages, Moody’s said. High defaults might be mitigated only by as extreme a method as principal forgiveness. Moody’s recommended a term extension to 40 years, significant interest rate cuts and some principal forbearance to keep borrowers’ cash flowing. “There is little hope that most of these [delinquent] borrowers will start making payments again if no principal is forgiven,” Moody’s said. “Forbearance does not eliminate the obligation to repay the loan principal, it only delays it. And many delinquent borrowers are potentially so far underwater that it would take close to a decade for them to attain any positive equity in their home.” The delinquency rate of Option ARMs is expected to rise as a wave of these loans recasts after the initial payment period, according to recent market commentary by Standard & Poor’s. “Option ARMs are the most vulnerable to quick payment increases because of the low payment options they offer borrowers,” S&P said. “Upon full recast, option ARM borrowers may experience sudden payment increases to varying degrees depending on the payment options they chose to exercise prior to the recast.” Write to Diana Golobay.