I have had strange problems like this before, but nothing exactly like this.
The hellos should be sent by each router as a keepalive method on point to
point lines, as well as to verify area id, subnet mask on the interface,
authentication, hello interval and so on, and you should see the state
transition to FULL eventually.  On a broadcast network you would see
FULL/DR, FULL/BDR, or 2WAY/DROTHER.  The full relationships are for the
designated and backup designated routers, the 2WAY indicates that the other
routers are there and OSPF is configured and functioning, but that there is
no adjacency formed (on a broadcast network).  See below:

Point to Point

r5#sh ip ospf neigh

Neighbor ID     Pri   State           Dead Time   Address         Interface
10.100.1.6        1   FULL/  -        00:00:33    10.65.1.1       Serial1

Broadcast

Neighbor ID     Pri   State           Dead Time   Address         Interface
x.x.x.x           1   2WAY/DROTHER    00:00:33    x.x.x.x
Ethernet0/0
x.x.x.x           1   2WAY/DROTHER    00:00:31    x.x.x.x
Ethernet0/0
x.x.x.x           1   2WAY/DROTHER    00:00:36    x.x.x.x
Ethernet0/0
x.x.x.x           1   2WAY/DROTHER    00:00:36    x.x.x.x
Ethernet0/0
x.x.x.x           1   2WAY/DROTHER    00:00:37    x.x.x.x
Ethernet0/0
x.x.x.x           1   2WAY/DROTHER    00:00:30    x.x.x.x
Ethernet0/0
x.x.x.x           1   2WAY/DROTHER    00:00:33    x.x.x.x
Ethernet0/0
x.x.x.x           1   2WAY/DROTHER    00:00:35    x.x.x.x
Ethernet0/0
x.x.x.x           1   2WAY/DROTHER    00:00:33    x.x.x.x
Ethernet0/0
x.x.x.x           1   2WAY/DROTHER    00:00:35    x.x.x.x
Ethernet0/0
x.x.x.x           1   2WAY/DROTHER    00:00:36    x.x.x.x
Ethernet0/0
x.x.x.x           1   FULL/BDR        00:00:30    x.x.x.x
Ethernet0/0
x.x.x.x           1   2WAY/DROTHER    00:00:36    x.x.x.x
Ethernet0/0
x.x.x.x           1   FULL/DR         00:00:39    x.x.x.x
Ethernet0/0

As far as your encapsulation failed problem, this usually indicates that the
router knows on which interface to send the packet, but for one reason or
another it cannot.  On a broadcast network this would indicate an ARP
problem as you stated.  I have seen issues where serial and line protocol
are up, but the timeslots are off by one, this causes some strange issues on
some hardware.  If the timeslots are off by any more than one you usually
would not see the circuit up, but in some instances the line will show up up
if only off by one time slot.  I would also check the MTU, as another person
suggested, I know from experience that mismatches cause serious problems
with multicast traffic.  I don't suppose you changed the MTU after you
brought the line up initially?  Did you try shutting it down and then
bringing it back up?  Can you ping the interfaces from each router?

~-----Original Message-----
~From: Fraasch James [mailto:[EMAIL PROTECTED]]
~Sent: Monday, January 14, 2002 5:46 PM
~To: [EMAIL PROTECTED]
~Subject: Encapsulation Failed [7:31916]
~
~
~I ran into a problem this weekend. I have a 7204 on one end 
~and an IBM 6611
~on the other of a point to point T-1.  IBM requires PPP 
~encapsulation.  I
~debugged and got the following:
~
~*Jan 12 02:57:19.231: IP: s=172.25.137.201 (local), 
~d=224.0.0.5 (Serial3/7),
~len
~ 64, sending broad/multicast
~*Jan 12 02:57:19.231: Se3/7 PPP: Outbound ip packet dropped, 
~line protocol
~not u
~p
~*Jan 12 02:57:19.231: IP: s=172.25.137.201 (local), 
~d=224.0.0.5 (Serial3/7),
~len
~ 64, encapsulation failed
~*Jan 12 02:57:19.347: LSP-TUNNEL-TIMER: timer fired for Tunnel 
~Head Checkup
~
~I know one of those lines says that the line protocol is not up but I
~guarantee that it is. We were switching out an existing router 
~that used
~that line just fine.
~
~The Cisco Tech I talked to wanted to talk about reversing the bits and
~seeing what that does.  That's crap.  It looks to be just an 
~ARP problem but
~I can fix it.  Has anyone other there ran into this problem 
~before, and if
~so, how did it get fixed?
~
~This is my first post. Please dont leave me hanging.
~
~
~Report misconduct 
~and Nondisclosure violations to [EMAIL PROTECTED]
~




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