Falling LIBOR May Decrease Defaults

The yield on the one-month and six-month LIBOR has tumbled recently to the lowest level in over three years as a result of a 200 basis point drop in the Fed Funds rate target since January, according to a new report from Standard & Poor’s Ratings Services. As a result, many hybrid ARMs could be favorably impacted.

For instance, payments on ARMs will be lower, resets will cause less payment shock and refinance opportunity will improve for ARM borrowers.

“These factors may lower the potential default risk for some hybrid ARM borrowers,” the report stated. “However, certain factors may offset this benefit, in our view, such as tighter underwriting guidelines and reduced investor appetite for mortgage loans.”

S&P said that 42 percent of Alt-A loans scheduled to reset this year are five-year hybrid ARMs, 51 percent are three-year and the rest are two-year. In contrast, just two percent of subprime hybrids are two-year, 26 percent are three-year and 72 percent are two-year.

While subprime borrowers with two-year hybrids who reset in December saw their payments jump 19 percent, the recent decline in the LIBOR pushed the payment increase down to just one percent for March resets.

But the decrease in payment shock is less evident with three-year hybrids.

“According to our analysis, as of March 18, 2008, the decline in six-month LIBOR from a 52-week peak of 5.6% has reduced subprime payment shock on the average two-year fixed-rate loan by as much as 95%, has virtually eliminated Alt-A payment shock and has made the post-reset payments easier for all borrowers to handle,” S&P said. “Combined with increases in income that the borrower has incurred during the fixed-rate period, this may, in our view, result in fewer borrower defaulting upon reset.”

The report indicated that while falling rates may enhance refinance opportunities, today’s tougher qualification and lower loan-to-values — especially given recent home price depreciation — may offset this.