With the increase in option ARM, or negative amortization loan, securitizations, rating agencies are starting to take a harsher look at these loans as evidenced by Fitch Ratings and Standard & Poor's revising enhancement criteria on these mortgages last week. These concerns also hit the mainstream press last Wednesday with the Wall Street Journal publishing an article on the same subject.
Aside from looking at the usual borrower characteristics - such as FICO scores, LTVs and the purpose of the mortgage - Fitch will be looking more closely at three key attributes: the teaser rate, the Index on which the loan's monthly adjustment is based (COFI, MTA or Libor), and the negative amortization balance cap.
"The lower the teaser rate, the more potential there is for the borrower to negatively amortize," Mark Douglass, head of RMBS research and modeling at Fitch said. If a borrower makes his minimum monthly payments based on the typical teaser rate of 1% to 2% during the first year of the loan, since the fully indexed rate underlying the mortgage is higher, the mortgage will negatively amortize, Douglass added.
Also, the minimum monthly payments change after the first twelve months, equaling the fully indexed interest rate plus the principal balance payments over the remaining term. However, these payment adjustments are typically capped at 7.5%, with the differential between the fully indexed rate payment and the capped rate payment accruing to the principal balance. The problem with capping payment adjustments is it could take less than the five-year recast period to reach the neg am cap, especially in a rising interest rate environment.
"Borrowers subject to this earlier payment shock might not be prepared to make the fully indexed payment," said Fitch Director Suzanne Mistretta, adding that there is more exposure on the loss side once the loan recasts. This is a double-edged sword since not having these payment adjustment caps raises the principal balance amount, increasing the loan's loss severity.
Analysts note, however, that a lot still depends on the type of borrower. "The borrower risk is based on how the product is being used," Mistretta added. Borrowers using the option ARM as a financial planning tool are expected to have a lower propensity to default while those using this product for affordability purposes may be more exposed to substantial payment shock and the lack of equity buildup.
Standard & Poor's also announced the revision of its criteria for option ARMs spurred by the change in borrower composition for these loans, according to Susan Barnes, managing director at S&P. Originally targeted towards high net worth individuals, neg am loans are now seen in the mainstream, Barnes said. In its release, S&P stated that it would assess the default risk on option ARM loans by looking at the adjustable interest rate impact. After which, analysts would assume a 20% increase in foreclosure frequency to address the potential payment shock. The loss severity for option ARM loans will still be determined according to the negative amortizing limit, said S&P.
While Moody's Investor Service said that it has had higher credit enhancement levels for negative amortization loans for a number of years, analysts from the rating agency acknowledge that there has been a considerable increase in securitizations backed by these loans, with a substantial pick-up starting last year. "We've been making a 15% to 20% adjustment for neg ams for a few years," Daniel Gringauz, a vice president at Moody's said. "We've always viewed neg am loans more harshly." The key difference in these loans is the lack of equity build-up together with the fact that the principal balance of neg am loans can actually increase, thus potentially resulting in the reduction of the equity in the borrower's property.
This increase in loan balance impacts the credit quality of a loan in two ways, according to Gringauz. The first is a higher LTV (assuming no increase in home value), which increases the likelihood that a loss would be incurred upon liquidation of the mortgaged property as well as the severity of that loss. The second is that, by reducing the borrower's equity in the house, the likelihood or frequency of that borrower defaulting increases.
Moody's looks at several key neg am loan characteristics, including the level of the neg am cap, the payment adjustment cap, the indexes used, and the teaser rates applied. Gringauz explained, for example, that the Libor index used in some neg am loans is more volatile than the MTA and COFI indexes used in other loans, and that this volatility could translate into more negative amortization. He added that it is also important to look at how low the teaser rates are on these loans because very low teaser rates increases the likelihood of negative amortization. A borrower with a very low teaser rate, for example, who chooses to make the minimum payment after the teaser period, could find his loan negatively amortizing even with no change in the index rate on his loan.
Dominion Bond Rating Service is generally concerned about option ARMs "because it is a volume driven product, and since early 1990 COFI Index-based neg am pools performed so poorly," said Dominion Senior Vice President Ken Higgins. Originally targeted to individuals who had short-term liquidity sources such as inheritance or bonus money, these types of loans are now being marketed to limited documentation or Alt-A borrowers with FICO scores significantly lower than prime mortgages, as well as towards investor occupancy properties.
"Lenders are testing the waters with lower credit borrowers to satisfy volume in the affordability product spectrum," said Bernard Maas, vice president at DBRS. In terms of credit enhancement levels, DBRS requires neg am pool-backed MBS rated single-B to retain 50 to 80 basis points versus 15 basis points on standard 30-year fixed collateral. Analysts have also given neg am MBS 7.5% to 10% credit enhancement levels for triple-A ratings, which represent the riskier side of Alt-A. DBRS also points to the risk layering inherent in these loans, although there is generally a 620 FICO score cut off for these borrowers.
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