The interest-only loan - a product that used to be the exclusive province of prime borrowers and wealthy homeowners looking to manage their finances - has begun to make inroads in the subprime market, according to a recent report from UBS.

An interest-only loan is not to be confused with the MBS security created by stripping interest payments from a pool of mortgages, as in an IO/PO. Rather, it is a loan that allows the borrower to pay only interest during the first two to five years, after which the loan begins to amortize and the borrower must pay both interest and principal. Some are questioning whether these loans leave subprime investors unduly exposed.

"The concern from a credit perspective is that because a borrower will not be building up equity in their home during the interest-only period, this type of loan will experience a higher default rate than will other loan types," analysts noted in the report. The lack of equity could potentially drive up loss severity as well.

"If you're doing this because this is the lowest possible way to squeeze into a house, it could create a risk," UBS mortgage analyst Thomas Zimmerman said.

Having already been established as a mainstream product in both Jumbo and Alt-A, interest-only loans started to appear more frequently in sub-prime transactions earlier this year, Zimmerman said. First Franklin, in particular, has been extremely active in this area and has issued deals comprised of between 40% and 60% of this type of collateral. No other issuer has a comparable concentration of no-interest loans in their deals, Zimmerman said. For most issuers, the average is somewhere between 5% and 10%, he noted. "First Franklin is a perfect example of a company going after a niche market," Zimmerman added.

Although First Franklin beat its peers to this market by several years, it is still too soon to draw conclusions regarding the performance of the underlying loans in these transactions, Zimmerman said.

To offset the undeniable risks associated with these loans, subprime issuers have taken steps to protect themselves via underwriting guidelines. For example, First Franklin stands out for the exceptionally high FICO scores of its interest-only borrowers. In addition, issuers are demanding lower investment properties - 1% for interest-only loans as opposed to 5% for typical subprimes. Full docs are also higher for interest-only borrowers relative to the rest of the sub-prime pool at 94% and 67%, respectively. However, Zimmerman was surprised to see that CLTVs for both interest-only and typical subprime loans were similar, with some reaching as high as 90%.

The ratings agencies and investors are taking an appropriately conservative approach to this product for the moment, Zimmerman said.

"[The ratings agency] concern is that since little performance data exists, it is difficult to judge whether or not the tougher underwriting completely offsets the inherent risk with this product," Zimmerman writes in his report.

This product might play a much larger role in the subprime universe moving forward if the explosive growth witnessed in the Alt-A sector is any indicator. In 2001, interest-only loans accounted for about 17% of Alt-A ARMs. By 2003, that number had jumped to 59%. "People really like this product," Zimmerman said.

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