Paradigm Shift in Subprime Debt Ratios

The Interagency Guidance on Nontraditional Mortgage Product Risks was released in October 2006. The guidance, which was issued by the Office of the Comptroller of the Currency, the Federal Reserve System Board of Governors, the Federal Deposit Insurance Corp., the Office of Thrift Supervision and the National Credit Union Administration, ultimately led to a final Statement on Subprime Mortgage Lending released in June.

The final guidance required lenders to qualify subprime ARM borrowers at fully indexed interest rates, according to research outlined in LoanPerformance’s The Market Pulse and authored by directors from Deutsche Bank. On interest-only or negative amortization loans, lenders are required to qualify borrowers based on a fully amortized payment.

The guidance applies to all federally regulated lenders, as well as companies regulated by states that adopted some form of the guidance as their own.

In addition to the regulated entities, mortgage market participants, including securitization investors, will likely follow the guidance — leaving noncompliant players likely stuck with illiquid loans.

“Now that the regulators have gone on record saying that this is the prudent way to lend, it may become harder for an originator who relies on capital markets to ‘buck the trend’,” the report said. “To the extent that the entire subprime market moves to fully-indexed underwriting, origination volumes will likely continue to decline, and defaults will continue to be negatively impacted … as less borrowers are able to refinance at favorable terms at the reset date.”

The authors said they examined LoanPerformance’s database of $467 billion in subprime mortgages originated from 2005 to 2006, of which $378 billion were ARMs. Second liens, high loan-to-value loans and scratch and dent deals were excluded from the review. Loans with missing data were also excluded, leaving a total sample size of $244 billion.

The report estimated pro forma front and back end debt ratios at fully indexed rates and fully amortized payments based on the original qualifying numbers and loan terms. When back end debt-to-income ratios were unavailable, 9 percent was added to the front end ratio.

The analysis showed that before adjusting to the pro forma figures, only 10 percent of the loans had debt ratios above 50 percent. But the pro forma adjustments left 60 percent of the loans above 50 percent DTIs. The weighted average DTI moved from 42 percent to 52 percent.

“It remains to be seen how rapidly the concept of underwriting to a fully-indexed rate is adopted, and whether the market simply accepts some shifting of the DTI distribution as a results,” the authors wrote. “But the clear message is that regulators feel that some products have been underwritten without sufficient prudence as to the borrower’s repayment ability under a variety of scenarios.

“No doubt many investors (and issuers) would agree.”