NEW YORK - From the rating agency to the investor panels and all throughout the different presentations, credit issues relating to ARMs were a big topic at the Bear Stearns first-ever Adjustable Rate Mortgage Conference 2005 held here last week.
As home prices have risen, panelists said affordability considerations have caused a spike in ARM issuance - particularly the more credit- sensitive versions such as MTA teaser ARMs and hybrid IOs - introducing new risks to the mortgage market. "ARMs are a cash-flow product as far as the balance sheet of the U.S. homeowner is concerned," said Steve Abrahams, senior managing director at Bear.
In his presentation, Bear Senior Managing Director Dale Westhoff said that the industry has "pushed the envelope" in terms of providing payment savings to borrowers. However, this also has the unintended consequence of limiting borrower options, specifically for those using non-amortizing products. For instance, MTA teaser ARM borrowers only have the option to refinance into another MTA ARM.
In the rating agency panel, participants brought up the issue of layered risk - including the lack of documentation and the rise in investor properties - making it hard to get comfortable with existing subordination levels. In some cases, rating analysts said that risks are not readily apparent, particularly as an increasing number of borrowers have taken on silent seconds. Even the reliability of FICO scores was questioned as panelists said that there have been instances where even if a borrower's FICO has not dipped, it still does not reflect his true ability to make monthly payments. Analysts also said that teaser rates also play a factor with deep teasers more like to negatively amortize.
Focus was on high-risk loans such as the IO and negative-amortization products, stating that loans with lower negative amortizing caps have a higher potential for payment shock. However, analysts said that many borrowers do not make full use of the negative amortization feature, often only for special occasions such as Christmas. Furthermore, Moody's Investors Service Senior Vice President Pramila Gupta said that in evaluating IO or neg am loans, focus should still be on borrower quality. For instance, many high-net-worth individuals are using these types of loans for tax purposes.
Meanwhile, investors said that the landscape for ARM investing has changed. As early as one year ago, investors were getting paid a liquidity premium because there were not that many people in the sector. However, merely a year later, valuations have gotten a lot tighter, added to the credit setback that many of the subordinate tranches in ARM deals could get hit. One problem, they said, is that there is currently a lot of supply in the product but not enough historical data to back investment decisions.
However, panelists said that ARM investors could protect themselves by making sure that subordination levels are adequate and by looking at factors such as the range of FICO scores and home price appreciation levels. Gagan Singh, a managing director at PNC Bank, said that decreasing home price appreciation rates could serve as a leading indicator for ARM collateral performance. He stated that it's not an unlikely scenario that as home prices correct, valuations could keep up. Panelists also mentioned geographic weak points, such as regions with unemployment problems or where income generation is concentrated in one industry such as Michigan. In the rating agency panel, usual suspect states such as California, New York, Florida and newcomers such as Nevada were mentioned as states to look out for.
Determining the real credit story in ARMs is not that easy as analysts try to sift through reported versus implied credit performance. In his presentation, Senior Managing Director Gyan Sinha talked about decoupling default frequency in the non-Agency sector from the spectacular performance of the housing market. "Credit analysis is made difficult by recent rapid home price appreciation which have dampened losses," said Sinha. In other words, accelerated home prices have resulted in far fewer recorded losses - which was the traditional default frequency measure and was the basis for categorizing a bad loan payoff from a good one. Sinha said that Bear Stearns' implied rule allows analysts to classify payoffs into good or bad regardless of loss information. Thus it is the loan's payment signature that would determine whether a loan's exit was good or bad.
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