Worst Is Yet to Come for ARM Shifts
The Associated Press
Updated: 3:57 p.m. ET Aug 10, 2007
NEW YORK - If you think defaults and delinquencies are high for subprime loans now, wait until the next wave of these loans shifts to higher rates.
Investors in mortgage bonds backed by subprime loans _ indeed, investors across all fixed-income asset classes _ are already feeling the pain as acute subprime credit troubles have caused a sharp repricing of risk, pushing down prices for all types of bonds except super-safe government securities.
But as high as defaults and delinquencies already are for the subprime loans that cater to borrowers with poor credit histories, they are poised to go much higher still. That's because subprime adjustable rate loans taken out in the second half of 2005 are starting to reach the end of their low fixed-rate period _ which typically lasts two years _ and shift to much higher floating rates.
That shift will cause monthly mortgage payments to rise for already stretched borrowers. And unlike those subprime borrowers who have already seen their mortgage payments rise, this next wave of borrowers will see monthly payments increase at a time when home prices are likely to be lower than they were when these loans were taken out.
With lending standards tightening drastically in recent months, these borrowers will face problems finding a lender to refinance their loans.
In short, going into the second half and especially the fourth quarter of this year _ and on into 2008 _ the borrowers who face higher payments for subprime adjustable-rate mortgages with two-year fixed-rate periods are going to be people who took those loans out at "exactly the wrong time," said Karen Weaver, global head of securitization research for Deutsche Bank in New York. And they are "just going to get hammered" between the decline in home prices and the clampdown on credit, she said.
From July until the end of 2007, according to Deutsche Bank research, about $150 billion in subprime ARM loans are due to shift to higher, floating-rate payments. And another $250 billion in loans are due to reset to higher rates in 2008.
For typical adjustable-rate subprime loans, the monthly payment will increase about 35 percent, said Jay Guo, director of asset-backed securities research for Credit Suisse in New York. For example, a borrower whose monthly payment is $1,000 will see that payment increase to $1,350.
That increase is substantial for subprime borrowers, who tend to have lower incomes than prime borrowers and are usually more financially stretched. Typically, 45 percent of a subprime borrower's pretax income goes toward paying their debts, said Weaver of Deutsche Bank. And that's at the lower, initially fixed rate of interest.
When the loans adjust, something more like 55 percent of pretax income is going to pay their debts, and "that's pretty hard to deal with," she said.
Already, about 14 percent of borrowers who are up-to-date on their mortgage payments just before the rates shift, slip two months (60 days) or more behind on their mortgages over a period of 12 months following the rate adjustment, Credit Suisse's Guo said.
"The pain of payment shock is indeed there," he said, and "will be even more severe" in future.
So far, subprime borrowers whose rates have adjusted higher this year have, for the most part, at least had the benefit of home price appreciation. That gave them some built-in equity in their homes, so that even if the new payment was too high most could still refinance their loans.
However, those options will diminish for borrowers who took out loans in 2005 or into 2006, when home prices started to fall in many cities, Guo said. As a result, "the delinquency rate will be much higher."
In the past, Weaver of Deutsche Bank said, borrowers with these types of adjustable-rate subprime loans with low initial fixed rates used to keep refinancing when the initial fixed-rate period was over. And as long as home prices kept going up, this was not a problem.
But now, "the music is over," Weaver said. Home prices stopped going up and turned negative. Defaults started to rise, performance of subprime loan-backed bonds suffered, Wall Street repriced the risk on these loans sending bond prices lower and yields higher. That made it difficult to sell packages of these subprime adjustable loans with initial two-year fixed rates into the secondary market for mortgage-backed securities.
Under pressure from regulators and politicians and facing lower profits from sales of certain subprime loans, banks tightened lending standards and few now offer the adjustable rate loans with low two-year fixed-rate periods anymore.
As a result, it's "fair to say" that higher payments for subprime borrowers as their loans adjust will be "more of a factor" pushing delinquency and default rates higher in the coming months, said Glenn Costello, a managing director in the residential mortgage-backed securities group for Fitch Ratings.
So far, for borrowers who took out subprime ARM loans in 2005, the number of those who were unable to refinance has been fairly small, Costello said. However, in the months to come, a larger number _ even of those who have been making payments on time all along _ will likely not be able to refinance their way out of difficulties, he said.
There are a few unknowns, of course. One wild card is the degree to which those institutions that are responsible for collecting mortgage payments _ the servicers _ will be able to modify the terms of subprime borrowers' loans to make the rate adjustment less painful for them. They could, for example, cut the payment increase once the initial fixed-rate period of a subprime adjustable-rate loan is over.
Recently, Moody's started approaching such servicer financial institutions to ask what their strategy is vis-a-vis subprime borrowers who will be facing upward shifts in monthly payments, said Nicolas Weill, chief credit officer in the structured finance team at Moody's. "Based on those results we will assess the effect on transactions" of rate adjustments, taking into account the potentially softening effect of interest rate modifications, he said.