It’s not exactly news that mortgage loans aren’t performing well. Negative loan performance stems from a variety of issues. Rather than a general discussion on the topic, in this brief article, I will be discussing my opinion on Adjustable Rate Loans (ARM’s) and how near-term loan performance will be affected by ARM’s resetting.
There are many individuals, both within and outside of the mortgage industry, that feel that the Federal Reserve’s recent multiple rate decreases, and the concomitant decrease in the yields of the indices on which ARM’s adjust, will result in better loan performance in the near term. While it is true that rates are coming down, that doesn’t mean that interest rate resets will not result in very large payment increases (thus potential inability to pay resulting in potential delinquencies and foreclosures) for a significant subset of Borrowers. Like the majority of currently poorly or non-performing loans, once again, Sub-Prime loans will be a major problem.
ARM Loans, other than Option ARMS (excluded because they work much differently), have three built in “protections” (at least in theory) for the Borrower; the initial cap, a periodic cap, and a lifetime cap. When a loan resets, the lender’s loan servicer takes the current index (for Sub-Prime loans, the index is almost always the 6 month Libor), and adds the margin in the Note to determine the effective rate for the next “period”. After the initial rate change, Sub-Prime loans typically reset every 6 months thereafter using the same methodology.
The problem is the “margin” and the initial rate cap. Unlike “A” paper and MOST Alt-A loans which typically have a 2.25% -2.75% margin (as an aside, they are also usually tied to a different index - either a shorter term Libor or the 12 month rolling T-Bill average), Sub-Prime loans frequently have a margin between 5.99% - 7.99%. As importantly, the initial cap on Sub-Prime loans is usually 2.00% - 3.00% above the start rate - which in the heyday of Sub-Prime lending was typically 4.99% - 6.99%.
Almost all Sub-Prime loans are 2/28’s or 3/27’s - meaning the loan is fixed for 2 or 3 years respectively prior to going to an adjustable rate. Here’s the math for a Sub-Prime loan funded in May 2006 using EXTREMELY conservative values:
Initial loan amount = $300,000.
Initial interest rate = 4.99%
Initial cap =2%
Term = 2/28
Margin = 5.99%
The payment for the first two years is $1608.63.
Since the loan is a 2/28, it is resetting this month. The current yield on the 6 month Libor is 2.6798%. Index of 2.6798 + margin @ 5.99% = 8.6698%. In this case, since the sum of the index and margin exceeds the initial cap, the rate will go up 2% - the initial cap. The Borrower’s new payment @ 4.99% + 2% (6.99%) is $1933.44. FYI, the new payment is based on a current loan balance of $290,905. to reflect the current unpaid principal balance based on timely payments for the 2 years at the 4.99% rate.
This is a 20% increase in monthly payment.
On November 1st, the new payment will LIKELY be $2132.53 based on a new interest rate of 7.99%, and an unpaid principal balance of $289,450. Remember, after the first change, the rate changes every 6 months. The periodic cap on Sub-Prime loans is almost always 1%.The Libor would need to go down to < 2% for the Borrower to pay any less than $2132.53. Why? 2% (6 mo. LIBOR) + 5.99% (again, the margin) = 7.99%, the maximum cap on that date.
This a 32% increase in monthly payment in 7 months
I don’t think I need to draw a detailed map to show the direction that near-term Sub-Prime loan performance is headed, regardless of the problems that have already surfaced.
Readers may find the following information interesting. Over the past few years, the 6 month Libor hit a low in June of 2003 @1.1239% and did not exceed 2% until August of 2004. By June of 2006, the 6 month Libor was at 5.6382%. Cheap money became very expensive very quickly with 17 consecutive rate hikes.
The good news, if there is any, is that the Fed has been somewhat aggressively lowering rates since August, 2007. I also believe that “A” paper and ALT A ARM loans SHOULD perform better than the doomsayers currently forecast… but, I’ll save my analysis of those loans for another day. The author, Dave Gray, is an 18 year mortgage industry veteran previously employed as a Chief Credit Officer and Director of Secondary Marketing. He is currently working as a mortgage industry analyst and consultant. He can be reached at davidsgray@sbcgloal.net. Register then tell us what you think on our Discussion Board
Who Do You Think You Are, Anyway?
I want to tell you who I think you are. I think you're a true industry professional looking to improve your own career, with good morals, sound ethics and admirable integrity as you engage in your activities here in the consumer residential real estate mortgage lending industry (or you wouldn't be among the Friends of Secret! University readership). Further, I'm reasonably sure you joined our industry since August 1998.
Given your years in the business, being raised somewhere along the timeline and the environment of the Aug.'98 to Dec.'05 cycle ... that gives you certain characteristics which differ from the people who grew in the cycle before that time - the '88 to '98 one, or those of us who entered the industry well before that (BTW, I hope you saw the September 2007 newsletter, it contains one of the best pieces I feel I have written about my eye-witness account of the last four (4) 'corrections').
Right now, you're enjoying the initial cleansing period, a sort of 'punishment phase' of today's overall cycle - that began in late Dec.'05 until ... (my guess 10 years in length) - the much shorter harsh 'punishment' portion of this new cycle should be over shortly, by the way.
Therefore considering your entry and exposure to both conforming and non-conforming loans during that period, your 'take' on what's needed today by you and others of your industry generation, is far less limited than say, mine.
At Secret! University, we pride ourselves on having a comprehensive mortgage education and training instructional curriculum, where you can Reach Higher because We Do More!
One such method of providing certain mortgage lessons, is via our CDs. Below is a listing of what's available today:
Emerging Mortgage Banker 101
LO Orientation 101, 201 & 301
Working at Home Originators 101
Secret! Resource Guide 101
Commercial Loan Brokerage 101
Advertising 101
Personnel 101 & 201
Going Out on My Own 101 & 201
Subprime 101 & 201
98 Ways to Find Customers 301
Superman's Cape 301
Lesson for the Times 301
We're open to your suggestions, made to order tailored projects, etc. Today I want to ask you to please let us know, which additional CDs do you think we should offer. Are there other topics you feel you and your friends in the business would like to pick up from us, if only they were offered. Register on our Discussion Board and help us expand the CD lessons we offer
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