Subprime Prepayments a Problem

Subprime loan prepayments have accelerated in recent years, despite that approximately 70 percent of subprime mortgage prepayments involved loans with prepayment penalties, according to the recently announced Why Have Subprime Loans Been Prepaying so Fast? study authored by Ralph DeFranco of Triad Guaranty and Paul Calem of LoanPerformance.

In an effort to find explanation behind accelerated prepayments, the researchers analyzed the annual prepayment speeds, or annualized cumulative prepayment rate, of loan pools consisting of subprime hybrid ARMs and fixed-rate mortgages originated in the first quarter periods of 2000 through 2003 and the first and second quarters of 2004. The pools had a loan-to-value ratio ranging from 71 to 80 percent and a FICO score ranging from 540 to 599, according to the study.

In the case of subprime ARMs, the study reportedly showed that one year into the life of loans originated in 2003, the prepayment speed was about 40 percent — more than double that of originations in 2000. Late 2003 marked a period of notable prepayment speed acceleration that continued into the next year in both subprime ARMs and fixed-rate mortgages, which were also found to have a pattern of higher prepayment speeds in loans originated in 2004 than those in 2003 and from years prior.

The acceleration of prepayment speeds in the second half of 2003, especially in ARMs, through 2004 were well above forecasts due to an economic environment that was unlike that in previous outlooks. Prepayments after mid-2003 reflected a “one-two punch” — the historically low market interest rates that bottomed out in June 2003 and house price appreciation rates that accelerated in 2004 to unprecedented levels in recent years, the researchers explained.

The study suggested the notable prepayment speeds in the second half of 2003 were driven by expectations of higher interest rates as these began to trend upward from June’s historic lows. Subprime hybrid ARM borrowers may have been motivated to refinance into a fixed-rate loan in order to preclude the possibility of a substantial increase in their monthly payment or into another hybrid ARM to delay the increase, while subprime fixed-rate mortgage borrowers who had not refinanced prior to June 2003 may have been prompted to do so primarily for a lower-rate loan, the authors said.

The continued wave of prepayments into 2004 was likely the result of rapid acceleration in house appreciation rates, which provided subprime borrowers with expanded opportunities to cash out equity, the study said.

While expectations of higher interest rates and higher levels of house appreciation were found to be the two primary drivers of the recent high prepayment activity, another influential factor has been the solicitation and marketing efforts of lenders to maintain volume amidst a competitive environment. Reaching out to subprime borrowers in specific by alerting of the opportunities to tap into home equity or to benefit from an improved credit rating may have ultimately influenced some borrowers to refinance, the authors explained.

The growing availability of interest-only loans was also associated to higher prepayment activity, according to the study. Although the degree to which the two directly link could not be determined, the researchers noted that some borrowers may have opted to refinance into IO loans to temporarily reduce their monthly payment obligation, although IO loans tend to be more popular amongst purchase-money borrowers.

As rates rise and house appreciation slows, however, the prepayment wave will dissipate and credit risk will become a key concern, according to the study.

“Potential credit risk will be most pronounced at ARM and hybrid reset dates and when interest only loans become fully amortizing,” the authors said.

Potential “vintage effects” on credit quality may also arise to the extent that the competitive environment led to relaxed underwriting and to the extent that recent prepayment activity has also been the result of adverse selection, where the borrowers refinance, despite a substantial prepayment penalty or costs associated with refinancing, primarily to lower their monthly payment, the study said.

Such borrowers, are of “lower credit quality than would be indicated by a credit score or other observable measure” and may “have less ability to withstand a payment shock as would result from an increase in their interest rate,” the authors said. “To the extent that such adverse selection has occurred, recent vintages ultimately may produce higher credit losses than would otherwise be predicted.”