Rising interest rates will probably increase the payment-shock risk for borrowers in the U.S. market for option adjustable-rate mortgages, which may lead to higher defaults and losses on option-ARM pools compared with interest-only or hybrid mortgage pools, according to Fitch Ratings.In a report on its revised rating methodology for option ARMs, Fitch said the degree of payment-shock risk and loan balance growth is determined largely by the initial teaser rate, the volatility of a particular index, and balance caps. "The higher payment-shock risk for the option ARMs is due to the minimum-payment option that keeps payments low for up to five years, but then can result in a 'recast' requiring a much higher payment," said Glenn Costello, a Fitch managing director. "That payment may reflect a larger balance, due to negative amortization. .... The borrower's risk of default is exacerbated in a rising rate environment." Fitch recently completed a historical analysis of over 65,000 negatively amortizing loans from 1994 through 2004. Fitch can be found online at http://www.fitchratings.com.

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