Not All Gloomy For Bondholders As Mortgage Rates Reset Higher

DowJones Newswires - May 2007

by Danielle Reed

NEW YORK--(Dow Jones)--If you think subprime defaults are high now, wait till you see what happens in the next 12 months.

A wave of adjustable-rate mortgages made to borrowers with less than stellar credit histories will shift to higher rates over the next year, causing more over-stretched homeowners to fall behind on their monthly payments. Worse, default rates are expected to double - bad news for investors in bonds backed by these loans.

Yet, there are a number of factors that may soften the blow for bondholders.

Securities backed by home loans, unlike more straightforward bonds sold by the U.S. government or companies, are complex instruments influenced by, among other things, borrowers' ability to refinance their mortgages.

The current flat home price and stricter lending environment mean that borrowers are less able to refinance, which turns out to be a modest positive for investors. Lenders' willingness to step in and renegotiate rate terms on some loans should also mitigate the fallout of a shift to higher rates.

Higher Default Rates

Over the next 12 months, $312 billion in subprime adjustable rate mortgages are due to shift from lower initial fixed-rates set two years ago to higher floating rates, according to Credit Suisse research.

The volume of loans shifting to floating rates has increased steadily in the last year. In the 12-month period starting September 2006, for example, just $236 billion in subprime loans were expected to change from fixed to floating rates, Credit Suisse said.

Most subprime loans have fixed rates for two years and then shift to adjustable rates for the rest of the loan's term. With short-term rates higher than they were two years ago - around 1.5 percentage points - that means borrowers can see substantial increases in their monthly payments after the fixed-rate term is over.

Based on historical data, said Michael Bykhovsky, president of San Francisco-based mortgage-backed bond research and modeling firm Applied Financial Technology, default rates typically increase two to three times for subprime loans that are shifting from fixed to floating rates.

In the past two months, on average, default rates for subprime bonds issued in 2005 have been approximately 1.2% and for bonds issued in 2006 have been 0.15%, according to Applied Financial Technology.

The rates are relatively low because it's early on in the process. It typically takes around 18 months for a loan to work its way through the foreclosure process.

When loans adjust to higher rates, borrowers with problem credit have three options - to make the higher payment, to refinance to new loans with lower payments, or to default, notes Joseph Mason, an associate professor of finance at Drexel University LeBow College of Business.

Because most subprime borrowers are financially stretched, many cannot afford a higher monthly bill. But, with home values no longer climbing and lenders more reluctant to extend credit, refinancing also will be tough.

"That leaves default as the third available option," Mason said.

Silver Lining

That said, as troubled as the situation looks in the coming 12 months for the subprime sector, there is a silver lining, at least for subprime mortgage bond investors. And, oddly enough, that silver lining is slower home price appreciation.

A cooling of home values can cause defaults to rise if fewer borrowers are able to refinance their loans before their mortgage payments increase.

However, for bond investors, fewer subprime borrowers refinancing their loans is also good news since it means more high-interest loans will stay in the pools of mortgages backing the bonds.

And because subprime bonds are structured so that more interest is paid by borrowers into the bonds than actually has to be paid out to bond investors - thus providing a financial "cushion" to absorb losses - keeping those loans in the pool also provides better protection for bond investors.

Another mitigating factor for loan defaults in the next 12 months is loan modifications. That's the term used when banks that collect mortgage payments actually change the terms of the loans for borrowers whose loans are shifting to higher rates, in some cases by actually lowering mortgage rates.

Loan modifications are being done with increasing frequency as banks try to avoid lengthy and expensive foreclosures, which can result in 40% losses once the properties are sold.

Slower rates of refinancing and loan modifications won't entirely prevent default rates from increasing on subprime loans that are shifting to higher rates, said Glenn Costello, managing director and co-head of Fitch Ratings' residential mortgage-backed securities group.

However, they definitely could soften the blow, he said.

-By Danielle Reed of Dow Jones Newswires