Nearly $1 trillion in subprime adjustable-rate mortgages are scheduled to reset this year and next year, according to an investment banking forecast. The rising payments will push losses higher -- with no improvement expected until 2009.
Mortgage credit will continue deteriorating through the end of 2008, Bank of America Securities LLC forecast in the recent report.
The analysts estimated approximately $515 billion of ARMs will reset this year and about $680 billion will do so in 2008, of which approximately $400 billion and $500 billion are subprime loans, respectively. This translates into more than 70 percent of ARMs facing reset belonging to subprime credit borrowers.
"We believe an increasing number of these borrowers will be forced into foreclosure, which with high [loan-to-value's] and stagnating or decreasing home prices, should dramatically increase credit losses through the end of '08," BoA analysts wrote in the report.
During the first quarter, subprime loan foreclosures were the main driver of the overall increase in foreclosures, to the highest level since March 2004, and largely contributed to the rise in new foreclosures, the strongest leading indicator for future foreclosures.
In 2006, more than three-quarters of 2/28 subprime ARM borrowers that had a reset were able to successfully payoff there loan through refinancing or selling their home. Of those who did not payoff their loan, 50 percent went bad.
As of this March, 18 percent of 2/28 subprime loans scheduled to reset this year have already gone bad or 29 percent of loans that have not been paid off, BoA noted.
Higher rates of credit deterioration will be seen, particularly for 2/28 subprime ARMs, BoA continued. Unless personal income growth accelerates and the unlikely event that unemployment rate plummets further from the current low level, already financially-stretched borrowers will be unable to afford the higher monthly mortgage payments and the delinquency ratio will only increase from the first quarter level.
Borrowers seeking to refinance will be unlikely to do so at lower rates than the original loan had, BoA explained. Additionally, many borrowers who qualified at a teaser rate or through stated-income may not be able to refinance if proposed legislation to qualify borrowers at the fully-indexed rate goes through as well as the proposal to eliminate stated-income loans or severely tighten underwriting standards on them.
If risky borrowers try to sell the property to repay the loan, the proceeds may not cover the outstanding loan amount and transaction costs, considering that recent subprime borrowers have taken out loans with high LTV ratios but home price appreciation has gradually slowed since the second quarter 2005 or even depreciated in some areas. The riskiest subprime borrowers may have very little or even negative equity remaining in their homes. With the outstanding loan amount exceeding the value of the house, borrowers lose their incentive to maintain the mortgage while their chance for voluntarily entering foreclosure increases.
"As home prices continue to remain stagnant or depreciate, we believe that lenders will come into possession of homes that may be worth less than the value of the outstanding loan," BoA wrote. "Also taking into consideration of foreclosure costs, we believe loan loss severity rates should rise from the current low level."
BoA expects loan loss severity rates to increase from last year's level of 7.1 percent to levels seen at the end of the last credit cycle --peaking at 31.1 percent in 1993. Assuming the same peak loss severity ratio in the last cycle, BoA assumes the foreclosure rate will increase by 70 percent from the level of 1.19 percent at yearend 2006 to 2.02 percent for 2008.
Increased loss severity and rising foreclosure rates will largely lead charge-off rates to peak at 90 BPS next year, BoA reported. Charge-off rates, which tripled over the year to 12 BPS in 2006, are expected to increase to 50 BPS this year and, after peaking, are anticipated to decline to 60 BPS in 2009.
Bear Stearns Companies Inc. recently said it will provide $3.2 billion in financing to The Bear Stearns High-Grade Structured Credit Fund to replace current financing from lenders including Merrill Lynch. Bear noted that in the past few weeks the High-Grade Fund and The Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund had experienced high levels of margin calls and have had difficulty in creating necessary liquidity and working capital to continue to operate the Funds.
BoA analysts noted the reported demise of two Bear Stearns managed Leveraged Mortgage Funds "could be the tipping point of a broader fall-out from subprime mortgage credit deterioration that would lead to cascading deleveraging and ultimately ending with higher rates to new mortgage borrowers."
"We think it foreshadows pressured gain-on-sale margins and more residual write-downs for originators while feeding back into weaker house prices by taking the marginal buyer out of the market through higher rates and further credit tightening," BoA wrote. "Gain-on-sale dependant lenders relying on private label securitization ... should be the most vulnerable."
Overall, higher charge-off rates through 2009 "will disproportionately impact lenders with high exposure of subprime and Alt-A, as well as other 'payment stretching' products, especially if the origination vintage mix is highly skewed to the recent two years when underwriting were lax and credit performance of the vintages are expected to be the worst."