Fitch Ratings has announced that it will adjust its treatment of interest-only affordability features on two- and three-year subprime hybrid adjustable-rate mortgages to reflect higher odds of default.Fitch analyzed the payment shock potential for 2005 subprime IO and non-IO ARMs and found that the payment increase for an IO at the rate reset is "significantly larger than the increase from principal amortization and is high even if rates do not rise due to the high margins and low initial rates." The credit performance of subprime IOs has been strong due to a favorable economic climate, but newer vintages "may not exhibit the same strong performance because more borrowers could face a payment increase as home price appreciation slows," said Fitch director Grant Bailey. Subprime borrowers are sensitive to the rate of home price appreciation because they tend to use accumulated home equity to pay off additional debt to lower their debt-to-income ratio. "If their DTI is too high to qualify for a new mortgage before the rate reset, they become vulnerable to payment shock risk," Mr. Bailey said. The report, "Rating Subprime RMBS Backed by Interest-Only ARMs," is available on Fitch's website at http://www.fitchratings.com.

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