Payment Shock Risk For U.S. Subprime IO ARM Borrowers Growing

Beneath the strong performance of U.S. subprime interest-only (IO) mortgages in recent years may lie substantial payment shock to borrowers as the housing climate continues to cool and refinancing becomes more difficult, according to Fitch Ratings in the latest edition of “Mortgage Principles and Interest”.

“The payment increase for an IO at the rate reset is high even if rates do not rise, and is mostly due to the rate reset with only a small portion comprising principal amortization,” said Suzanne Mistretta, Senior Director, Fitch Ratings. “Because subprime IOs have high margins and low initial rates, the payment increase from the rate reset could range from 40% to over 50%, and the high margins assure that the initial rate cap, which hovers around 3%, is reached.”

Fitch also studied the effect of the payment increase on the IO borrowers’ debt to income ratios (DTIs) and found that the IO borrower’s DTI rises by a larger percentage compared to a hybrid ARM borrower’s DTI, all else being equal. The effect on the IO borrower’s DTI is attributable to the qualification of the IO borrower at a lower IO payment.

Future vintages may not exhibit the same strong credit performance as earlier vintages because more borrowers could face the payment increase if home price appreciation slows and borrowers are faced with fewer refinancing opportunities.

When rating residential mortgage backed securities (RMBS) backed by subprime IOs ARMs, Fitch applies two frequency of foreclosure (FOF) factors to the base FOF. One of the FOF factors applies to all ARMs and addresses the payment shock risk faced by the borrower when the payment increases due to the rate reset. If the ARM has an interest-only period, a second FOF factor is applied to address the larger payment increase faced by the IO borrower and the impact on their DTI. “By the time IOs reach the rate reset, a borrower’s mortgage payment-to-income ratio may jump by as much as 11%, and that is assuming the six-month LIBOR does not increase” said Mistretta.

The “Mortgage Principles and Interest” edition also highlights refinancing trends and the percentage of the subprime sector scheduled to reset for the first time in 2006. “If a subprime IO borrower were to refinance into a 30 year fixed rate mortgage today, the payment would be less than the fully indexed IO payment,” said Grant Bailey, Director, Fitch Ratings. “Therefore, it’s a safe bet that the actual loans that reach the rate reset in 2006 will be smaller than the projection.”

Fitch will be rolling out its formal rating criteria on subprime IOs next month. The latest edition of “Mortgage Principles and Interest” is available on the Fitch Ratings web site at www.fitchratings.com under “RMBS” and “Newsletters.”