As an increasing number of subprime borrowers choose the 40-year mortgage - and an increasing number of issuers offer them - investors are wondering how they stack up against an interest-only loan.
According to UBS, anecdotal evidence indicates that the 40-year loan product constitutes as much as 30% to 35% of some subprime mortgage issuers' current loan volume. At least one issuer, Ownit Mortgage Solutions, has unveiled a 45-year mortgage product. More companies are expected to follow in its footsteps (ASR, 2/13/06).
"This is a major change in the collateral mix for subprime - the question is whether it will have a major impact on a borrower's ability to make their mortgage payments," said UBS in research released last week.
The investment bank found that, in terms of payment shock, there is not much difference between the 2/28 IO loan and the 2/28 40-year loan. Anecdotal evidence suggests that lower quality borrowers are rolling into the 40-year product compared with those who qualified for an IO loan. Lower required credit enhancement on the 40-year product, among other factors, is expected to allow the product to eat away at IO market share in the subprime arena.
A number of issuers, including New Century Financial Corp., have decreased their interest-only volumes following an up-tick in investor, rating agency and regulatory concern surrounding the product. New Century reduced the volume of IO loans it was originating, as a percentage of its overall volume, to 21% in the fourth quarter of 2005, from 35% in the third quarter and 38% in the second.
Qualifying on interest
When the mortgage first became popular in the subprime space, some issuers such as Novastar Financial Inc. were qualifying borrowers on their ability to pay the interest-only portion of the payment, not the full payment the borrower would face down the road. Fitch Ratings pointed out that a borrower's debt-to-income ratio rises substantially - by as much as 11% - when the interest-only period of the mortgage ends. Investors are particularly worried about later vintage IOs issued because the borrowers are likely to have a lesser benefit from home price appreciation that earlier subprime IO borrowers would have enjoyed.
"Because subprime IOs have high margins and low initial rates, the payment increase from the rate reset could range from 40% to 50%, and the high margins assure that the initial rate cap, which hovers around 3%, is reached," said Suzanne Mistretta, a senior director at Fitch.
The 40-year product gives borrowers a smaller payment like the interest-only loan. The most common 40-year loan product offered in the subprime market is a 30-year loan that uses a 40-year amortization schedule and a balloon payment at the 30-year mark, according to UBS.
UBS compared the principal and interest payments and total payment shocks of four types of 2/28 hybrid adjustable-rate mortgages: a fully amortizing 2/28 hybrid ARM with a 30-year maturity; a fully amortizing 2/28 hybrid ARM with a 30-year maturity; a fully amortizing 2/28 hybrid ARM with a 30-year maturity but a 40-year amortization schedule; and two 2/28 IOs, one with a two-year IO period and the other with a five-year IO period. Each loan had an initial 8% coupon and an 11% coupon for the floating-rate period.
Payment shock
The investment bank found that a traditional 30-year 2/28 loan had the smallest payment shock when smaller monthly payments turned into larger payments. That loan type showed a 28.7% increase in payments, or $210.23. The 40-year 2/28 loan provides borrowers with a lower initial rate, but a greater payment shock than the 30-year amortizing mortgage, at a $228.96 increase. While the increase is not a huge sum, borrowers using the 40-year amortizing loan will still have a balloon payment to contend with once that mortgage hits the 30-year mark, UBS said.
The 2/28 IO loan with a two-year IO period gives a borrower lower initial payments as well. But when the loan payments increase to include payments on the loan principal as well as a higher coupon, borrowers in this scenario face a 44.2% payment increase, in line with the Fitch Ratings analysis, and $70 more each month than with the 40-year product. With the five-year IO product, borrowers face a monthly payment increase of $250 when the interest rate resets after the initial two years, and an additional increase of $63.44 when the five-year IO period is up.
UBS concluded that, "regardless of which type of 2/28 is considered - the reset itself, and the borrowers' ability to refinance their loans, are the two major questions facing subprime borrowers. Taking out a 40-year loan rather than an IO will do little to change those issues."
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