by Calculated Risk on 10/16/2011 08:02:00 AM

From economist Tom Lawler:

Many folks have for some strange reason argued that safe and effective loan modifications for troubled borrowers should get these borrowers into 30-year fixed-rate mortgages – even though short-term interest rates are close to zero, and expected to stay close to zero “until at least 2013.” One reason, of course, is that the typical ARM offered by US lenders has been one where the margin over the short-term index rate used has been really high – 275 bp for prime borrowers and often 600 bp for “subprime” borrowers. Such margins have been well in excess of the effective margin of fixed-rate mortgages over the full Treasury curve, after adjusting for the option cost of the prepayment option.

If, however, an adjustable rate mortgage with a “reasonable” margin were offered to struggling borrowers, it might just be worth the “risk” of having these borrowers take some interest-rate risk in exchange for lowering their risk of losing their home, by having a larger share of their reduced payment going to principal pay down.

Many struggling borrowers, of course, are in danger of losing their homes in the short- or intermediate-term, and it’s not clear if putting such borrowers into a long-term fixed-rate mortgage which includes prepayment risk in the rate is the “best” for such borrowers.

As an example, consider a borrower who has a mortgage with a $200,000 balance, a 6.5% current interest rate, and 25 years (300 months) left to maturity. Suppose further that (1) the home’s current value is, say, $160,000; (2) the borrower’s current monthly income is, say, $52,000 a year; and (3) the borrower pays about $250/month in taxes and insurance.

Currently that borrower’s total mortgage payment is around 37% of her income, and she is $40,000 (20%) under water. In addition, a comparable home today would rent for less than her mortgage payment.

Now suppose one were to offer her two options: (1) modify her rate to a 4.5% fixed-rate loan that amortizes over 25 years; or (2) modify her rate where her payment was the same as a 4.5% 25-year fixed-rate loan, but her actual interest rate (or accrual rate) was set for the first 12 months at 1.50% -- which is about 140 bp over the one-year constant maturity Treasury rate – and would then adjust each yearly anniversary to a rate equal to the one-year constant maturity Treasury rate plus 140 bp.

If interest rates were to follow current forward one-year interest rates, then her interest rate would increase by less than 50 bp a year from now, and then about 50 bp the year after that. But for simplicity’s sake, let’s just assume that in each of the next four years, the one-year Treasury rate increases by 50 bp. Let’s take a look at what the borrower would face over the next several years.

First, of course, the borrower’s mortgage payment would decline by the same amount for both loans – about 15% (her P&I payment would drop by about 18%) – to about 31% of her income.

Here is what her mortgage principal balance would look like at the end of each of the next 5 years (1) for the original loan; (2) for the 4.5% FRM loan; and (3) for the ARM.

Remaining Mortgage Principal Balance, $200,000 Loan
End of Year:	6.5% 25yr FRM	4.5% 25yr FRM	1-Yr ARM 25yr Am
1	$196,698	$195,569	$189,589
2	$193,174	$190,935	$179,872
3	$189,415	$186,088	$170,850
4	$185,404	$181,018	$162,449
5	$181,124	$175,716	$154,600

Because the 1-year ARM is based on a 4.5%, 25-year amortization schedule but the accrual rate is based on the very low short-term interest rate, a much larger % of the borrower’s payment goes to paying down principal – which is shown graphically in the above table. If interest rates were to increase by just 50 bp each year, the borrower’s mortgage balance would fall below TODAY”S value of her home in four years and four months. For the 4.5% fixed-rate loan, the borrower’s mortgage balance would not fall below $160,000 for seven years an nine months.

Of course, the borrower in the ARM case would be exposed to the risk that interest rates would increase. However, this borrower is already at significant risk of defaulting. Moreover, the borrower might be more WILLING to accept the ARM offer once she saw that her mortgage balance was falling so fast.

CR Note: This was a proposal from Tom Lawler for Seriously-Troubled Loans.

Yesterday:
• Summary for Week Ending Oct 14th
• Lawler: Early Read on Existing Home Sales in September
• Schedule for Week of Oct 16th