Fitch Says Mods Will Cushion Rate Shock

One of the pressing issues facing mortgage servicers today is what will happen as an estimated $418 billion of subprime credit quality adjustable-rate mortgages reset to higher interest rates.

Many were originated with "teaser rates" that kept payments low in the early going. Worse yet, many of the loans were not underwritten to assure that borrowers would be able to keep making payments once the loans adjusted to "fully indexed" payments. This is especially a concern for hybrid loans, which were fixed for an initial two- to five-year period typically before recasting as ARMs with annual payment adjustments.

The six-month LIBOR was the rate most widely used to index subprime, hybrid ARM loans, Fitch noted. In mid-October, LIBOR reached a recent peak that could have caused subprime borrower payments to increase by 30% to 50%, Fitch said. On average, Fitch estimates that borrowers facing an initial reset would see their monthly bill increase by $331, or 19%. Those facing a subsequent reset would see their bill increase by an average of $153, or 11%.

Of the $418 billion of subprime ARM loans outstanding, Fitch estimates that $347 billion, or 1.8 million loans, are within six months either from their initial reset or a subsequent reset date. Those payment increases would likely drive many more loans into default, but Fitch says that wide-scale modifications of subprime ARMs are helping to mitigate the payment shock.

According to Hope Now, mortgage servicers provided loan modifications for 98,000 borrowers in September. Deducing from a recent increase in loan workout activity, Fitch says that over one million of the 1.8 million subprime borrowers should find some form of relief over the next six months. But workouts include repayment plans, which do not change the terms of the loan and therefore still leave borrowers facing payment resets. So far, Hope Now data show that repayment plans have exceeded the volume of modifications, but the share of workouts that involve modifying a loan's terms has been on the rise. Under Hope Now's streamlined modification program, troubled borrowers can receive a rate freeze at the initial loan rate for five years, which may help many avoid foreclosure. Fitch senior director Suzanne Mistretta said that because of declining home values and tighter mortgage underwriting, many borrowers can no longer refinance out of a problem loan.

"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," she said.