Option ARM Loan Modification Outlook Dismal

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Those nasty pick-a-pay mortgages, the ones that allowed borrowers to pay less than interest thereby adding to principal balances every month, continue to be among the most worrisome mortgages still going bad.

And modification efforts are going nowhere. Lots of folks, including The Motley Fool and a Mortgage Law Network blog continue to lament the failure of modifications so far. The problems seem to be particularly acute with option ARMS. About 40% of the option adjustable rate mortgages that were underwritten in 2006 and 2007 are already delinquent. But less than 10% of those loans, which have accumulated higher balances because borrowers were allowed to defer more than just interest, have been modified. The worry is that when the interest rates and payments eventually recast to higher payments (as the loan contract calls for) yet even more borrowers will throw in the towel and go delinquent.

New Barclays Capital research from Sandeep Bordia and colleagues shows that the recasts in the next year or so are expected to be a minor event. But by mid-2011, these borrowers are forecast to see payments that are 50% to 80% higher than what they are grappling with now. (Many of these option ARMS are concentrated in former hot-spot real estate markets, such as California and Florida.)

Modification don't seem to be working with these particularly noxious loans. In the face rising payments, borrowers don't have an incentive to keep up with their current payments for homes that are already so horrendously under water, i.e. the loan amount is far above the current value of the property. Bordia says that many of the option ARM loans that do get modified turn delinquent soon after anyway. They've crunched some numbers and forecast that 95% of the loans that are slated for modification will eventually default. If you think that sounds bad, get this: They say that 80% of the option ARM loans out there that are ok and up-to-date as of right now will eventually default, too.

Maybe that bit of new analysis will finally dispel any lingering notions that these loans were intended and sold to only the very best credit quality home buyer.

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