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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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