Many U.S. prime and Alt-A mortgage borrowers that are making interest-only (IO) monthly payments will experience a payment shock over the next year due to a recasting of these IO loans to full principal and interest (P&I) payments, according to Fitch Ratings.
Over $47 billion of prime and Alt-A residential mortgage-backed securities (RMBS) collateral is due to recast over the next 12 months from an IO payment to a fully amortizing payment. This recast exposes borrowers to an average payment increase of 15% and possibly higher if interest rates increase. Over the next two years, a total of $80 billion of prime and Alt-A loans and a total of $50 billion subprime loans are due to recast.
This payment shock will have a substantial effect on the recasting population, according to Fitch Managing Director Roelof Slump.
"Sixty-day delinquency rates have risen over 250 percent in the 12 months following previous recasts for prime and Alt-A loans," Slump says.
Fitch's current ratings consider the risks of upcoming IO recasts, but Slump warns that "mortgage pools with significant interest-only loan concentrations may be downgraded if performance is worse than anticipated."
Recasts typically have a significant impact on loan performance. While only 3.3% of prime loans are 60 or more days delinquent prior to recast, delinquencies the year after recast increase to 9.3%, Fitch says.
Similar effects have been seen in Alt-A and subprime, with delinquencies increasing from 12% to 29% for Alt-A, and from 20% to 58% for subprime. Furthermore, "declining borrower equity is still eroding refinancing opportunities and incentives to continue payment," Slump adds. On average, current loan-to-value ratios for prime and Alt-A loans are 118%, with 64% of borrowers having negative equity.
The effect of higher expected defaults on IO loans figures to be relatively small on the overall market, because these loans account for only 8% of the securitized non-agency market, Fitch notes. However, there is significant performance risk in RMBS transactions with high concentration of IOs, particularly if a large portion of loans recast around the same time.
As it was not uncommon to see IO concentrations of greater than 50% in certain securitizations, performance on these pools will be particularly hard-hit by recasts. If observed IO performance results in higher-than-expected loss estimates for Fitch-rated RMBS, this situation may result in further negative pressure on long-term ratings and/or Recovery Ratings, the agency says.
Loans with an IO feature were available across all of RMBS and were compatible with both fixed- and adjustable-rate mortgage (ARM) products. Fixed-rate IO borrowers only face a payment increase equal to an amount of principal amortization when the IO period ends, with the payment staying fixed thereafter for the life of the loan. ARM IOs also have interest-rate risk, where the payment can increase based on prevailing interest rates at the reset date. In today's environment, ARM IOs will only face a payment increase from principal amortization when the IO period ends. However, "if rates rise on subsequent reset dates, so will the monthly payments," Slump says.
Of IO loans recasting in the next two years, 99% of prime, 94% of Alt-A and 90% of subprime are ARM loans. Furthermore, borrowers were often qualified for loans on their ability to make initial IO payments rather than the full P&I payment to which their loan would adjust, and on 63% of prime and Alt-A loans, this qualification was made with less than full documentation of income, Fitch points out.
Most IO ARM loans featured interest rates based on Treasury or LIBOR interest rates plus a margin. Payment shocks can be mitigated by market interest rate decreases for prime and Alt-A ARMs. Subprime interest rates are typically floored at the initial rate, which prevents borrowers from benefiting from a decrease in rates.
As interest rates are at historic lows, some prime and Alt-A loans that had high initial rates, but low margins, will not experience a payment shock at recast even when the principal repayment component is taken into consideration. However, current average payment shocks are estimated at 15%, and each 1% rise in the benchmark rates corresponds to an approximate 10% increase in payment shock, Fitch explains.
SOURCE: Fitch Ratings