New York - As the most rapidly growing loan type within the home equity ABS sector, interest-only (IO) loans represent an X-factor for most in the market and only time will tell if the subprime borrower will be able to manage higher monthly payments upon reset, or refinance into a new mortgage prior to the reset period.

Analyst David Liu told a panel of investors that while IO product has outperformed all other loan types in the prime sector, IO loan evolution into subprime has set off red flags investors should be concerned with. The solid performance in the prime sector was credited more with the financial strength of the borrower, who was in turn taking advantage of the frontloaded interest payments. The subprime IO borrower, however, is showing some disturbing characteristics for the most popular type of IO structures.

Since moving into subprime, IO loans have stormed into the home equity market. The bulk of securitized IO loans are currently in 2003 vintage transactions, Liu pointed out, adding that these loans have yet to reach their first rate reset. The most popular IO type to date, has been the 2/28, with a reset every six months, after the second year.

The typical 2/28 subprime IO loan has a 661 FICO score, 83.6% loan-to-value ratio and a 44.3% debt-to-income ratio. Typical size for these types of loans is $239,000, UBS reported in its presentation. Countrywide Home Loans Inc. is the leading IO loan originator to date, Liu added.

Assuming a modest 100 basis point increase in Libor during the IO period, a typical borrower can expect a 28% increase in monthly payments upon reset, according to UBS. Using a 300 basis point increase in Libor, a borrower would face a 52.2% increase in monthly payments, increasing the borrower's DTI ration in the process to an estimated 61%.

Also worrisome is the fact that IO loans are being used to get subprime borrowers into homes in high cost-of-living geographic regions, such as California, that they would otherwise be unable to afford.

In response to the spate of IO loan originations, the rating agencies, which have expressed concern over the trend in the past, are increasing credit enhancement within securitizations containing higher percentages of IO loans. The GSEs, which collectively purchase more than 50% of the triple-A home equity ABS supply, have capped IO loan exposure in their investment portfolios.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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