Fitch: Loan Modifications Will Cushion Rate Shock on $347B of U.S. Subprime ARMs

NEW YORK--(BUSINESS WIRE)--The dramatic increase of London Interbank Offering Rates (LIBOR) from mid-September to mid-October has reignited concerns regarding payment shock for borrowers of U.S. hybrid adjustable-rate mortgage (ARM) collateral and particularly subprime RMBS, according to Fitch Ratings. However, Fitch anticipates that the ongoing efforts to work-out subprime loan terms, including modifications and repayment plans, will help to mitigate such impacts on subprime borrowers.

The six-month LIBOR rate was the most widely used index for subprime hybrid adjustable-rate mortgages (ARMs) and hybrid interest only (IO) loans. 'As LIBOR rises, hybrid ARM borrowers become exposed to payment shock at their interest rate reset. For example, at the recent peak in mid-October, the rate adjustment could have caused subprime borrower payments to increase by 30-50%, particularly for loans with deeply teased initial rates,' said Managing Director Roelof Slump. 'While LIBOR has been trending lower from its recent highs, it continues to be of concern, as it directly impacts borrower affordability, and ultimately collateral and bond performance,' Slump added.

Of the outstanding $418 billion of subprime ARM loans, a total of 1.8 million loans, or $347 billion in outstanding principal balance, are on average approximately half a year away from either their initial or next rate reset date. A total of 0.4 million loans (totaling $102 billion) are two-year hybrid ARMs that provide for a two-year fixed-rate period and reset to six-month LIBOR thereafter and have not yet reached their initial rate reset. At the recent LIBOR peak, these borrowers would have seen increases from their rate reset of 8.27% to 10.27%, which would cause their monthly payments to increase by an average of $331, or 19.3%. Additionally, 1.4 million loans, totaling $245 billion of the total outstanding subprime ARMs, are past their initial rate reset. Based on recent peak LIBOR rates, these borrowers would have seen increases from their initial rate of 8.80% to 9.96%, which would cause their payments to increase further by an average of $153, or 10.7%. Fitch notes that these statistics reflect original loan terms, and that loan modifications have already reduced the amount of mortgages at risk of payment shock.

The pace and number of work-out plans have picked up noticeably in 2008. To date, the majority of work-out plans have consisted of repayment plans and rate modifications. Repayment plans allow for missed principal and interest to be capitalized and repaid while concurrently making timely mortgage payments. Rate reductions provide for the borrower to pay a lower rate of interest for a specified period or permanently. Few loans have had principal forgiven.

Fitch anticipates that the use of the modification plans will continue to rise, helping borrowers facing a rate reset avoid default. According to data provided by the Hope Now alliance, mortgage servicers provided loan workouts for approximately 212,000 borrowers in September 2008, with approximately 113,000 homeowners receiving repayment plans, and approximately 98,000 receiving loan modifications. September modifications were 22.5% higher than the 79,000 completed in August 2008. Total subprime modifications were approximately three-quarters of the total of all performed in the third quarter of 2008.

If the loan workout level continues at the pace evidenced in 2008, then over 1 million of the 1.8 million subprime borrowers should find some relief over the next six months. Servicers which are not included in the Hope Now data may also be increasing their subprime workout activity, thus further contributing to reduce borrower stress. In particular, the Hope Now streamlined modification plan that provides for a rate freeze at the initial rate for five years may help borrowers who have been current with the initial payment avoid becoming delinquent due to payment shock.

Prior to the credit crisis, borrowers facing initial rate resets and higher mortgage payments would have refinanced into a new lower cost mortgage. However, Senior Director Suzanne Mistretta said that the steep decline in home prices combined with tighter credit underwriting standards have rendered many borrowers unable to refinance. 'Modification programs have increasingly been made available to borrowers who can't afford the higher payments in order to help them stay in their home as it may be the only alternative to foreclosure,' said Mistretta.

To the extent that the modification initiatives are successful in offering alternatives to borrowers that are encountering either first-time or repeat rate shocks due to an increase in LIBOR, the actual impact of these changes may be less extreme. Fitch will continue to monitor the potential credit implications of these rate movements, and their effect on the performance of loans contained in RMBS mortgage securitizations.

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