The uncertainty surrounding the future performance of subprime interest-only loans is getting a lot of attention from analysts lately, with mostly upbeat news for investors.
A Fitch Ratings report offered the most cautious take on the sector, saying the favorable IO performance to date does not reflect the potential risks. But Fitch analysts believe that payment shock is not likely to be a significant factor in 2006.
"We feel the '06 vintage is likely to have a lot of prepayments again because these are borrowers [who] took out their loans in 2004. They probably have accumulated home equity since then and are going to be able to refinance," said Suzanne Mistretta, a senior director covering RMBS for Fitch. "Our concern extends beyond 2006. It's more for the IOs that will reset in 2007 and 2008."
Expect higher IO delinquencies
Mistretta said IO delinquencies are expected to increase by a few percentage points in 2006, which does not represent a severe increase.
"We found that subprime IOs have very high margins," she said. "If six-month LIBOR stays at today's level, borrowers are still going to incur about a 40% to 50% payment increase at the initial rate reset, whether it occurs in '06, '07 or '08."
However, Mistretta believes most of those resetting in 2006 should be able to refinance.
A Fitch analysis showed that if these borrowers refinance into a 30-year mortgage, their monthly payment would be lower than the fully indexed IO payment at reset.
Mistretta also expects the new 40-year mortgage product to be a boon for many IO borrowers. But she said the risk of payment shock is still a cause for concern in future years. The biggest issue is whether home price appreciation will slow, hindering the ability of IO borrowers to refinance, Mistretta said. However, Fitch's criteria addresses these risks, she added.
With IOs there is a higher payment increase relative to other hybrid ARM products and a much more severe impact on the debt-to-income ratio, Mistretta said. Fitch applies a frequency-of-foreclosure factor for IOs when determining its ratings. Fitch also intends to publish criteria specifically for subprime IOs this week.
Incomes on the rise
Michael Youngblood of Friedman Billings Ramsey said analysis by his firm indicates that the annual increase in the incomes of IO borrowers should exceed the scheduled mortgage payment increases, which should help mitigate payment shock.
"There is a decently solid advantage of income over the anticipated payments," said Youngblood, who added that this holds true for the vast majority of metropolitan statistical areas.
He said this advantage could be wiped out if the Fed raises rates extraordinarily high - in excess of 6%. But there is no indication that will happen. Another caveat would be any event that significantly reduces the growth rate of personal income. But historically, incomes and inflation have tracked together, he added.
Youngblood said borrowers likely will increase their discretionary spending as their incomes increase. They may have to cut back to adjust for higher mortgage rates.
"I'm not saying it's going to be painless or frictionless," he said. "All I'm saying is that the income numbers suggest that most borrowers should be able to make the higher payments."
Analysts at Countrywide, which is consistently one of the largest RMBS issuers in the market, said in a recent report that investors are wary of the outlook for subprime IOs, but they cited several factors they believe should lessen the concern, including the favorable performance to date.
An analysis of production covering 2004 through mid-2005 shows subprime IOs generating lower cumulative 60-plus day delinquencies than non-IO mortgages, the report said. This measure has a strong correlation to defaults across products.
"Although it remains to be seen how IOs perform after the IO period ends, the strong early performance is a positive," the analysts wrote.
They attributed the outperformance of IOs to superior borrower characteristics, including higher FICO scores, larger loan balances (which tends to decrease loss severity) and the lack of nonowner-occupied properties. Less than 3% of IO loans are for investor properties, compared to 8% for non-IO loans. Throughout 2004, the average FICO differential between IOs and non-IOs was 44 points.
Despite concerns that the FICO differential might erode over time, that credit trend remains in place. The analysts cited a differential of 45 points for the third quarter of 2005.
Higher CLTVs are one point of caution for the sector. CLTVs average about 5 percentage points higher for IOs, which makes future home price appreciation much more important to these borrowers, the report said. The report also said the explosive growth of IOs appears to be coming to an end, stabilizing at about 30% of the market over the past three quarters. The analysts believe this indicates that lenders are not drifting toward lower FICO borrowers with the IOs.
The market is addressing the potential impact of payment shock with new products, including subprime IOs with a five-year, interest-only period and the initial rate fixed for two or three years, they added. Data from Moody's Investors Service indicates that was the most common structure for subprime IOs in 2005, comprising about 65% of total volume. This helps mitigate double payment shock, plus the longer IO period increases the likelihood of home price appreciation, which would enable refinancing, the Countrywide report said.
The new 40-year mortgages also represent an affordable alternative for subprime borrowers relative to amortizing loans.
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