Last year net interest margin (NIMs) activity was robust, but views are mixed on the future of the market. As regulators continue zeroing in on lending abuse, lenders could be forced to pare down the use of prepayment penalties, currently the strongest cash flow to a NIM.

In the late 1990s, several NIMs failed. Back then they were structured with longer average lives and did not capture prepayment penalties. Incorporating the penalties into the structure acts a "natural" hedge.

Specifically, the Office of Thrift Supervision (OTS) has been eying the use of penalties, which many consumer advocates denounce as unfair. Lenders in turn argue that those penalties and other similar clauses allow them to offer credit to borrowers whom they otherwise could not justify lending to because of poor credit.

The OTS has sided with consumer groups and announced it would remove prepayment penalties and late-fee rules from the list of OTS regulations applicable to state housing creditors under the Alternative Mortgage Transaction Parity Act.

The final rule was published in the Federal Register last September; however, it is scheduled to become effective on July 1, despite originally scheduled for implementation this past Jan. 1.

"The delay in the effective date responds to several requests, submitted after the close of the comment period, from interested parties concerned about compliance burdens imposed by the original effective date," officials at the OTS said in a statement that followed the Jan. 6 announcement of the moratorium. "After considering those requests, OTS agrees that a delay is desirable to permit entities affected by the rule change adequate time to prepare for the effect of the changes."

The Parity Act effectively allows multi-state lenders, who worry about the increasing amount of regulatory burdens on the state level, to apply certain rules of one state in another. For example, many lenders choose the prepayment laws of California, if they are already operating in that states. California's prepayment penalty guidelines are preferred because the regulation is fairly clear, and complying with it is less costly.

But with the OTS mandate, NIMs could lose their wings. For example, how would that additional cost, or loss of previously anticipated cash flow from prepayment penalties, affect the performance of a NIM?

"The performance over the last year has been very different from what we modeled," said Lal Mahabir, a structured finance surveillance analyst at Standard & Poor's. "We had models first for 60 months and then 32 months. Many of the assets repaid the entire principal in 16 to 18 months."

Rating analysts noted through the year that the NIMs were generating more in excess spread than had been presumed, in some cases warranting upgrades. The pass-through to NIMs was significantly greater than anticipated due to record low rates, while the senior classes are paying a spread off Libor.

"Even if the subprime market is in the tank, delinquencies and foreclosures do not come through for 10 to 18 months," Mahabir said. "During that time, in most cases, the NIM has been paid back. So even in the case of the worst performing collateral, in most cases the NIM gets paid off before the cash flow going to the NIM is affected."

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