Performance on U.S. option adjustable-rate mortgage (ARM) residential mortgage-backed securities (RMBS) is likely to continue its decline, as $134 billion of these loans will recast over the next two years, according to Fitch Ratings.
Of the $189 billion securitized option-ARM loans outstanding, 88% have yet to experience a recast event, though it should be noted that Fitch rated only approximately 5% of option-ARM transactions. Of these loans that have not yet recast, 94% have utilized the minimum monthly payment to allow their loans to negatively amortize.
"Having not demonstrated their ability to make payments at the full rate, option-ARM borrowers are at the greatest risk of default resulting from payment shock," says Group Managing Director and U.S. RMBS Group Head Huxley Somerville.
Further evidence of the product's underperformance in the last year lies in the number of outstanding securitized option-ARMs that are either 90 days or more delinquent, in foreclosure or real estate-owned proceedings, which has increased from 16% to 37%. Total 30+ day delinquencies are now 46%, despite the fact that only 12% have recast and experienced an associated payment shock.
Instead, negative and declining equity has presented a larger problem. Due to high concentrations in California, Florida and other states with rapidly declining home prices, average loan-to-value ratios have increased from 79% at origination to 126% today, Fitch says. "Negative equity and payment shocks will continue as option-ARM loans recast in large numbers in the coming years," says Somerville.
Option-ARM loans have been a concern for some time, specifically because of negative amortization. This feature allows for the loan balance to grow over time – typically to a balance cap of 110% to 125% of the original mortgage.
Once the loan hits the balance cap or reaches 60 months in age – or "recasts" – the borrower's monthly payment obligation increases from a minimum monthly payment to a fully amortizing principal and interest (P&I) payment. This fully amortizing P&I payment is, on average, 63% higher than the minimum monthly payment, and it can be more than double, depending on loan attributes and interest-rate behavior.
Overall, Fitch's expected losses for recent-vintage option-ARMs range between approximately 35% and 45%, depending on the collateral quality of the underlying mortgage loans. In addition to expectations of higher defaults, severities have also contributed to higher expected lifetime losses.
Fitch has observed that loss severities on option-ARMs have increased significantly, to an average of approximately 60%, from 40% a year ago.
A key driver in the worsening severities is the fact that 75% percent of option-ARM loans are secured by properties located in California, Florida, Nevada, and Arizona, which have experienced average declines of 48% from the second-quarter of 2006.
SOURCE: Fitch Ratings