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Are Borrowers Overburdened?

The analysts at Fitch Ratings recently studied consumer debt patterns to ascertain whether or not consumer debt burdens are too high. Among their findings: total consumer debt is currently at 113% of personal income, while the personal savings rate stood at 2.2% in the first quarter. This viewpoint is an excerpt from their report, titled "U.S. Consumer - Overburdened or Underestimated?"

Over the past five months, economic conditions in the U.S. have been positive with buoyant gross domestic product and broad-based employment gains across industries. Rising housing prices, higher tax refunds and the low interest rate environment, which has allowed consumers to take "cash out" from the value of their homes and pay down existing debt, has propelled consumer spending, leaving households in good shape. Or has it? Driven primarily by asset appreciation in home values, household net worth has risen 11.8% from $39.8 trillion in 2002 to a record $44.5 trillion at the end of 2003. At the same time, total liabilities have increased in lockstep from $8.8 trillion to $9.8 trillion, while the debt service burden at 18.4% in December 2003 remains at historically high levels. Moreover, while debt service costs remain at a manageable level, total consumer debt is at 113% of personal income, while the savings rate for the first quarter has stayed in the 2.2% range.

Low mortgage rates and rising home equity have supported consumer spending through a substitution effect, effectively trading home equity for cash while keeping monthly payments at a manageable level. Now that mortgage rates are rising again, refinancing activity is falling and so are cash-outs, what is the impact of higher interest rates on the consumer?

While difficult to determine whether consumers have stretched themselves too thin, with Fed rate hikes imminent, likely 100 to 150 basis points by this time next year, Fitch Ratings remains concerned about the potential impact on consumer behavior and collateral performance, especially in the subprime consumer asset-backed securities and mortgage products segments.

The immediate downside risk of rising interest rates is the impact on refinancing activity, home prices and collateral performance in the mortgage sector. Indeed, there has already been a sharp slowdown in mortgage refinancing. According to the Mortgage Bankers Association's weekly gauge, refinancing activity is down approximately 82% from its record peak in March 2003. Moreover, a potential correction in home prices is likely to further impair household cash flows. Overall, Fitch projects some stress for subprime residential mortgage-backed securities as a result of rising interest rates but no severe short-term shocks.

During the past several years, RMBS market participants have benefited from extremely low mortgage interest rates, very high rates of housing price appreciation in many areas of the country, and large production volumes. In 2003, upgrades accounted for nearly 80% of all rating changes, a significant proportion of all rating changes (although slightly smaller than occurred in 2002 and 2001).

Indirectly, rising rates and poor performance in the residential mortgage market may have a spillover effect, adversely impacting the performance of other consumer ABS products. Most notably, the higher interest carry cost along with challenged home prices may induce the reloading of revolving debt, primarily through the increased use of credit cards negatively impac-ting performance, especially for the subprime borrower. Adjustable-rate mortgages have, over the last few years, become increasingly popular. Across the mortgage market sector, different people have opted for ARMS over fixed-rate mortgages for a variety of reasons - some by choice, others by need to qualify for certain mortgage amounts. Origi-nators, on the other hand, have been innovative in bringing to market a wide variety of ARM products for borrowers across the credit spectrum, further fuelling the growth of this product. Currently, 40% of outstanding mortgage debt in the prime sector and around 65% of outstanding mortgage debt in the subprime sector is in some variable-rate product. This is a significant increase in the preponderance of variable-rate products, especially given the fact that mortgage rates have been at historical lows.

With the economy improving and interest rates poised to rise, home sales are expected to slow and home prices cool off as mortgage rates increase from historical lows. The most robust house price gains have been concentrated in California, Florida, and the Northeast corridor between Boston and Washington, while price gains in the rest of the country have been modest. The low interest rate environment of recent years have been capitalized in house prices as homebuyers have bought as much housing as they could afford. A rise in the interest rates will lead to unwinding of this effect and will cause house prices to weaken considerably, especially in certain "housing bubble" markets - markets where house price growth has been stronger and faster than historical trends. However, the housing market is not headed toward a collapse similar to the Northeast in 1989-1991 and California in 1992.

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