Increased Defaults as Interest-Only Loans Recast -Fitch

The ghosts of originations past could still come back to haunt the housing industry according to a new report from Fitch Ratings.  The company says that half of those borrowers who have loans in performing residential mortgage backed securities (RMBS) are facing increases in their mortgage payments over the next five years.

Fitch says the mortgages that will be affected by increases are those with adjustable interest rates (ARMs), loans that have had interest only payment features (IOs), and loans that were modified to save or redeem them from default.  Fitch notes that payment increases have historically led to high rates of default with a correlation between the size of the payment increase and the default rate.   

'Interest-only loans are in store for the largest payment increases,' said Director Sean Nelson. 'As a wave of peak vintage 10-year IOs approaches recast, many mortgage borrowers could see their monthly payments more than double.'

ARM payment increases are typically tied to short-term interest rates so the magnitude of those increases are expected to be smaller than for IO loans as long as rates continue at the current pattern.  Modified loans typically have scheduled and limited rate increases so borrowers should suffer less payment shock. 

Fitch says the prime jumbo sector has the most exposure to future payment increases due to a larger composition of ARM and IO loans. Nearly two-thirds of performing prime jumbo loans are at risk, whereas less than half of subprime loans are exposed to future payment hikes.

Any payment increases are expected to have little impact on its ratings Fitch says.  Its US RMBS Loan Loss Model projects payment increases and adjusts the probability of default accordingly. 'While default rates are expected to increase for loans with an upcoming payment hike, the elevated default risk is already baked into our RMBS ratings,' said Nelson.