NEW YORK--(BUSINESS WIRE)--Performance on U.S. option ARM 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,' said Group Managing Director and U.S. RMBS group head Huxley Somerville.
Further evidence of option ARM underperformance in the last year lies in the number of outstanding securitized Option ARMs 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. 'Negative equity and payment shocks will continue as Option ARM loans recast in large numbers in the coming years,' said Somerville.
Option ARM loans have been a concern for some time specifically because of negative amortization. This feature allows for the loan balance is able to grow over time; typically to a balance cap of 110%-125% of the original mortgage. In an event known as 'Recast', once the loan hits the balance cap or reaches 60 months in age, the borrower's monthly payment obligation increases from a minimum monthly payment to a fully amortizing P&I payment. This fully amortizing P&I payment is on average 63% higher than the MMP, and can be more than double depending on loan attributes and interest rate behavior. These concerns at the securitization issuance are largely what drove Fitch to rate such a small number of Option ARM transactions.
To date, 3.5% of the approximately one million 2004-2007 vintage securitized Option ARM loans have been modified, in an attempt to mitigate effects from the payment shock. Modification types have included term extension, conversion to interest only loans, interest rate cuts, and others. These modifications have been somewhat successful, with 24% of modified Option ARM loans being 90+ days delinquent, compared with 37% of the overall Option ARM universe. However, because this product features lower MMP payments than would be available after recast, even with substantially favorable modification terms, there may still be material payment shock. Therefore, Fitch expects a high default percentage for modified Option ARM loans.
Overall, Fitch's expected losses for recent-vintage Option ARMs range between approximately 35%-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 second quarter-2006 to date. Even without further declines in home values, defaults on Option ARM loans are expected to soar as loan recasts occur, as these borrowers are unable to effectively refinance into alternative mortgage product.