Payment Shock Concerns Grow as Billions in Interest Only Loans Face Recast Date
FitchrnRatings warned today that billions of prime and Alt-A mortgages that werernwritten as interest-only (IO) loans are due to recast over the next two years. $47rnbillion of these loans convert to fully amortizing loans in the next 12 monthsrnand a total of $80 billion in Prime and Alt-A loans and another $50 billionrnSubprime loans will recast by the end of 2011. These conversions will result inrnsubstantially higher monthly payments.
While IO options were writtenrninto both fixed rate (FRM) and adjustable rate mortgages (ARM), over 90 percentrnof the loans in each category, prime, Alt-A, and subprime, are ARMs becausernthose offered borrowers the lowest payments and many borrowers qualified onlyrnbecause of these artificially low payments. In addition, 63% of Prime and Alt-A loans qualified basedrnon less than a full documentation of income.
As MNDrnreported, in September Fitch warned that $134 billion in Option ARMs wouldrnrecast by the end of 2010. Option ARMs are mortgages that allow the borrower tornchoose each month among making a fully amortizing payment, an interest onlyrnpayment, or a smaller payment that does not cover all of the interest. In thernlast case the remaining interest is added to the mortgage balance. Fitch estimated that 94 percent of Optionrnborrowers had exercised the lowest payment option, allowing the loan to negativelyrnamortize. These loans will recast bothrnas fully amortizing loans and at a higher balance than the borrower qualified for.
Because interest rates havernremained low, many of the IO loans due to recast will have payment increasesrnonly to the extent necessary to begin amortizing and some may actually have thernpayment shock mitigated by a lower interest rate. However, many Subprime loans have an interestrnrate floor that does not allow the rate to drop below the initial one and, inrnsubsequent years, all borrowers will probably suffer additional payment shockrnas their loans go through periodic rate adjustments. Just considering thernamortization component or the recast, current average payment shocks are estimated at 15%, and each 1% risernin the benchmark rates corresponds to an approximate 10% increase in paymentrnshock.
Whilernhistorically only 3.3 percent of Prime loans have been seriously delinquentrnprior to recast, the 60 day delinquent rate rose to 9.3 percent within arnyear. Alt-A loan delinquencies havernincreased from 12 percent to 29 percent and Subprime loans from 20 percent torn58 percent. In the current climate borrowers also have less incentive torncontinue payments as their equity has significantly eroded or disappeared.
IO loans account for only 8rnpercent of the non-agency RMBS market so the impact of expected defaults onrnthese loans will be relatively small. However, in certain securitizations thernconcentration of IOs can be greater than 50 percent. These securitizationsrncould be at risk, particularly if large numbers of IOs recast at the same time.rnFitch pointed out that performance on these pools will be particularly hard-hitrnby recasts. If observed IO performance results in higher than expected lossrnestimates for Fitch-rated RMBS, this may result in further negative pressure onrnlong-term ratings and/or Recovery Ratings (RRs).
Fitch Ratings ManagingrnDirector Roelof Slump said “60-day delinquency rates have risen over 250%rnin the 12 months following previous recasts for prime and Alt-A loans,' saidrnSlump. Even though Fitch's current ratings consider the risks of upcoming IOrnrecasts, 'mortgage pools with significant interest-only loan concentrations mayrnbe downgraded if performance is worse than anticipated.”
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