High Cost Fuels Demand for Interest-Only Products

With recent economic news showing that the U.S. economy is in a steady growth phase, and the Federal Reserve signaling that higher interest rates are a possibility, more consumers are going to look to interest-only mortgages to sustain housing affordability, especially in the subprime IO sector, and it's with these non-agency MBS products that investors may find value.

Although in the marketplace for several years, consumers demanded IO mortgages in a big way in 2004 and 2005 as home prices continued to climb, particularly along the coasts and other high-cost markets. Long-term mortgages inched higher from near all-time loans and more consumers sought the lower payments offered by IO mortgages.

In 2005, between 7% and 8% of the total mortgage market consisted of subprime IO mortgages, or as much as $220 billion, based on data from Moody's Investors Service and MSN surveys.

And while it's too early for a definitive viewpoint on how subprime IO mortgages will perform once their initial interest period expires, a new report by Countrywide Securities suggests that mortgages in this sector have to date performed better than amortizing subprime mortgages.

According to data gathered from Loan Performance, a subsidiary of First American Real Estate Solutions, Countrywide reported that the cumulative 60+ day delinquency rate for subprime IO mortgages originated between January 2004 and June 2005 was about 5%, while the 60+ cumulative delinquency rate for amortizing subprime mortgages was nearly 10%.

While at first counterintuitive, the fact is underwriting standards on subprime IOs are more stringent and may contribute to their better performance to date. For example, Countrywide noted that the FICO scores for average subprime IO mortgages originated in 2004 is approximately 44 points higher than for non-IO subprime mortgages. That spread increases slightly to 45 points through the first half of 2005 at a time when many observers expected credit standards to soften as originators chased after volume.

In addition, Countrywide points out that subprime IO mortgages are "almost exclusively for owner-occupied properties." Investors generally have less stake in a property than owners and this may also contribute to better credit performance of subprime IOs than other subprime loans. And for investors who may wonder about potential loss severity on the subprime IO mortgage if it goes to default, another positive is the higher loan balance of these loans over their non-IO counterparts. All else equal, noted Countrywide, "low loan balance loans tend to experience greater loss severities due to the fixed costs associated with defaulted loans."

But not everything is perfect with subprime IO mortgages. As you would expect, the combined loan-to-value ratio of these mortgages is above the non-IO product. Higher LTVs generally point to higher delinquency rates. According to the Countrywide report, the CLTV for subprime IO deals closing in October was 92.3% vs. 85% for non-IO subprime deals.

An upside here may be found in continued bullish forecasts for home price appreciation. The February economic outlook from Freddie Mac released last Wednesday still sees home prices climbing nearly eight percent in 2006, muting some of the CLTV risk present in the subprime IO product.

Moreover, a growing economy, evidenced by last week's report that initial jobless claims were 277,000 - about 12,000 applications below the four-week moving average - suggests that subprime IO borrowers (and other borrowers for that matter) likely won't have to worry about a recession.

Meanwhile, spreads continue to be wide over in the non-agency prime IO market. Investors who can allocate cash to the non-agency sector, may also want to look at these securities, according to recent analysis by RBS Greenwich Securities. Strategists there wrote in a recent report that IO non-agency pass-throughs "are cheap and have room to tighten." They note that more investors are buying this product and that should drive spreads tighter.

But one key factor is slowing interest in the IO sector. One of the biggest hurdles to overcome when investing in IO products is the lack of prepayment data on the mortgages, which makes it difficult to value the bonds. Nevertheless, as investors compare the yields available with these products today to other MBS, there is a very good chance that spreads won't remain this wide for long.

(c) 2006 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com http://www.sourcemedia.com

Next in News ►