In a conference call last Tuesday discussing the impact of current historically low rates on adjustable rate mortgages now being originated, Standard & Poor's has concluded that a rise in interest rates would not cause adjustable-rate mortgage borrowers to default on their loans.
The conclusions were based on an analysis of personal income growth along with different interest rate forecasts to pinpoint the degree to which some of these borrowers may be stretched in making future payments on their mortgages. S&P's premise was that if mortgage rates rise, there is the risk that borrowers who qualified under the initial mortgage rate could no longer pay the principal and interest payments. This, therefore, increases the possibility for defaults.
The rating agency considered four different scenarios. Each of the scenarios presented the effect of income growth and changes in the ARM rate on P&I payments for an adjustable mortgage loan.
"Primarily we found that for the scenarios that we looked at, there is really no real concern from a payment shock perspective," said S&P analyst Frank Parisi at the call. Parisi also mentioned that payment shock risk is actually reduced by the short effective maturities that are caused by prepayments as well as the borrowers' option to go into fixed-rate mortgages once rates start to rise.
One scenario that the rating agency looked at is when income growth averages roughly 3% each year and interest rates surges to 5.17% from a starting rate of 3.86% in the initial year of the mortgage. In this case, the ARM rate remains over 5.5%, peaking at 5.88% for the remaining years two through eight. It is interesting to note that the payment-to-income ratio peaks at the first reset year at 16% and then starts to dip. S&P said that this scenario - with personal income increasing at an average of 3% per year and interest rates rising only moderately - is the most probable of the four cases the rating agency considered. S&P said that there is no payment shock risk in this scenario because the front-end ratio is always below the 28% standard underwriting guideline.
In a report released prior to the conference call, Parisi wrote that under the more likely scenarios, increases in disposable income are enough to offset increased P&I payments that are due to interest rate moves. Furthermore, even under the more unlikely scenarios, the homeowner's debt-to-income ratios were still within standard underwriting guidelines. For instance, even under these extremely unlikely but still possible cases, the monthly P&I payment peaks at 26% after eight years, which is below the standard initial front-end ratio of 28%.
In other words, the rating agency said that when the change in disposable income is forecasted and utilized in analyzing debt-to-income ratios under rising interest rate scenarios, it seems that the risk is minimal under the various scenarios studied by S&P. Considering the forecasts, the correlation between change in income and change in rates, and the seven-year average life of a typical mortgage, ARM mortgages being originated today should not result in higher-than-average default rates if interest rates rise going forward.
In the conference call, Parisi said that the borrowers used for the study were those S&P typically sees in subprime pools. These borrowers have an average income of about $60,000 and a loan size of about $150,000. In the report, he also noted the residential mortgage loan origination topped $2.4 trillion last year, with adjustable-rate mortgages comprising roughly 17% of that volume.