Michael Youngblood, head of ABS research at Friedman Billings Ramsey, said last week that investors should be more concerned about the general prospect of payment shock to be experienced by all adjustable rate subprime borrowers - either with a hybrid ARM or an interest-only ARM - than with those loans' form of amortization. Youngblood said the general characteristics of IO ARMs and hybrid ARMs are nearly indistinguishable, and where there are material differences - such as the borrower's credit score - the IO loans actually come out looking better, contrary to the skeptical views of the subprime IO loan by many market participants.
For example, as of February, the average FICO outstanding for IO product was 667, whereas the average FICO for a fully amortizing loan was a 626, he said, and early credit performance of IO loans is superior to fully amortizing loans with comparable loan-to-value ratios.
"We see no evidence that lenders have generally relaxed underwriting standards, or underwriting standards particularly on IO loans," Youngblood said.
Conforming interest-only ARMs often include simultaneous resets for the rate and amortizing transitions, creating a dual shock for borrowers, whereas subprime lenders have generally tiered this transition by as much as three years. Subprime IO ARMs typically offer a fixed rate for two, three, or five-year periods, and IO periods of five years, according to FBR.
However, high geographic concentrations, rising short-term interest rates and the specter of a lowered pace of home price appreciation could sour the IO loan type's so-far rosy default and delinquency statistics.
FBR researchers found the gap between prospective payment increases and income increases of subprime hybrid ARM borrowers is significantly larger for IO borrowers than fully amortizing borrowers.
For example, the researchers found that the 2/28 IO average mortgage payment would increase in the 12 months following the reset by $2,876.82, while per-capita personal income would grow $1,262.28 - creating a $1,614.54 shortfall - or 56.1% of the mortgage payment over the time period. In that instance, nine of the 10 areas with the greatest shortfalls were located in California. And while the 3/27 IO had an average shortfall of $2,545.3, the fully amortizing 2/28 had an average of $239.08; and the fully amortizing 3/27 had an average shortfall of $750.41
Additionally, 81.8% of IO loans are located in only 31 of the 331 metropolitan statistical areas, and of these, 54.9% are located in 14 California, and 60% are located in 19 of the 33 areas experiencing home price bubbles as of the fourth quarter of 2004.
Separately, JPMorgan Securities recently concluded its first loan-level analysis of New Century Financial Corp.'s servicing portfolio since the Irvine, Calif.-based subprime lender began using a new servicing platform in late 2002. New Century, the nation's largest REIT and second-largest subprime lender, originated $42 billion of loans last year, and expects volume to reach at least $45 billion this year.
Roughly 98,000 loans have been boarded onto New Century's new servicing platform since October of 2002; previously, loan servicing was sourced to a third party. Also, some 95% of the lender's ARM portfolio has not reached its first rate reset.
Researchers found home price appreciation, low mortgage rates and the competitive lending environment have increased voluntary repayment rates and reduced delinquency and default rates, and noted that investors should treat a future decline in loan performance due to slowed home price appreciation as a "return to normal' rather than a decline in collateral performance."
"New Century's default frequency and loss severity statistics are exceptional," JPMorgan researchers wrote. As of March, 168 loans had defaulted: 120 of which were ARMs, 47 fixed-, and one interest-only loan, and loss severities ranged from 14% for hybrid ARMs, to 30% for fixed-rate mortgages.
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