With mortgage lenders like New Century Financial Corp. introducing 40-year mortgages to their customers, supply is seen growing in the sector going forward.
Although not seen as presenting significant additional risk versus 30-year mortgages, tiering and adverse selection is expected as 40-year borrowers typically have a lower credit profile, even compared to I/O mortgages. In fact, there is some anecdotal evidence suggesting that some lenders are offering borrowers deemed ineligible for an I/O the 40-year product instead.
At a press conference held last Wednesday, Fitch Ratings Managing Director Glenn Costello characterized 40-year mortgages as less risky than other "affordability" products that have a risk of payment shock. Fitch gives 40-year mortgages a 5% hit to compensate for the additional default risk based on the higher implied LTV on the loan due to slower amortization than 30-year products. Costello added that Fitch has seen pools that have both option ARMs and 40-year mortgages and the combination does not represent a significant amount of risk layering. He added that 40-year production is rising slowly, with borrowers not eligible for an I/O, sometimes opting for a 40-year mortgage instead. This could cause some credit tiering in the subprime mortgage market between these two sectors, Costello explained.
"We think the risk of 40-year mortgages is rather marginal compared to 30-years, from an amortization or payment shock perspective," said Dominion Bond Rating Service Senior Vice President Quincy Tang. However, adverse selection becomes an issue as borrowers who do qualify for a 30-year mortgage would not typically opt for a longer, 40-year loan. There are, Tang said, certain levels of adverse selection from a leverage standpoint such as higher debt-to-income ratios, combined LTVs, and percentage of piggybacks in 40-year loans. Thus even though DBRS does not treat 40-year loans much worse in terms of amortization and payment shock, the higher leverage translates into higher credit enhancement levels. Furthermore, 40-year programs tend to have more aggressive underwriting guidelines compared to their standard 30-year equivalent, causing DBRS to treat 40-year loans harsher on a grade and documentation basis.
One issue that is hindering the growth of the 40-year sector is that some buyers, particularly CDO investors, are restricted from investing in securities with greater than 30-year final maturities. "As long as it can be demonstrated that the loans will pay off comfortably before the 30-year mark, under extreme prepayment and default circumstances, we are able to sign off on the issue," Tang said, adding that market players have been able to sidestep the issue by either creating 40-year loans that balloon in 30-years or by creating a reserve fund to make sure that these 40-year mortgages are fully paid in 30 years.
Ultimately, borrower behavior still depends on what is available. "I don't think there's a constant incentive. It will depend on rates and programs," said an analyst, adding that a 40-year loan is much longer than the 10/20 I/O loan, making it worse from a credit perspective. "It does not seem to be a long-term subprime product - it's hard to view it as more than a gimmick," the analyst added. For instance, monthly payments on 40-year loans are higher than that on 10/20 fixed-rate I/Os, even if rates are the same, and 40-year loans generally carry higher interest rates due to their greater credit risk. Also, 40-year loans amortize less than 10% of its balance in the first 120 months, so "it's hard to argue that the borrower's equity situation is improved by taking a 40-year versus a 10/20," he stated.
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