Fitch Ratings warned today that billions of prime and Alt-A mortgages that were written as interest-only (IO) loans are due to recast over the next two years. $47 billion of these loans convert to fully amortizing loans in the next 12 months and a total of $80 billion in Prime and Alt-A loans and another $50 billion Subprime loans will recast by the end of 2011. These conversions will result in substantially higher monthly payments.

While IO options were written into both fixed rate (FRM) and adjustable rate mortgages (ARM), over 90 percent of the loans in each category, prime, Alt-A, and subprime, are ARMs because those offered borrowers the lowest payments and many borrowers qualified only because of these artificially low payments.  In addition, 63% of Prime and Alt-A loans qualified based on less than a full documentation of income.

As MND reported, in September Fitch warned that $134 billion in Option ARMs would recast by the end of 2010. Option ARMs are mortgages that allow the borrower to choose each month among making a fully amortizing payment, an interest only payment, or a smaller payment that does not cover all of the interest. In the last case the remaining interest is added to the mortgage balance.  Fitch estimated that 94 percent of Option borrowers had exercised the lowest payment option, allowing the loan to negatively amortize.  These loans will recast both as fully amortizing loans and at a higher balance than the borrower qualified for.

Because interest rates have remained low, many of the IO loans due to recast will have payment increases only to the extent necessary to begin amortizing and some may actually have the payment shock mitigated by a lower interest rate.  However, many Subprime loans have an interest rate floor that does not allow the rate to drop below the initial one and, in subsequent years, all borrowers will probably suffer additional payment shock as their loans go through periodic rate adjustments. Just considering the amortization component or the recast, current average payment shocks are estimated at 15%, and each 1% rise in the benchmark rates corresponds to an approximate 10% increase in payment shock.

While historically only 3.3 percent of Prime loans have been seriously delinquent prior to recast, the 60 day delinquent rate rose to 9.3 percent within a year.  Alt-A loan delinquencies have increased from 12 percent to 29 percent and Subprime loans from 20 percent to 58 percent. In the current climate borrowers also have less incentive to continue payments as their equity has significantly eroded or disappeared.

IO loans account for only 8 percent of the non-agency RMBS market so the impact of expected defaults on these loans will be relatively small. However, in certain securitizations the concentration of IOs can be greater than 50 percent. These securitizations could be at risk, particularly if large numbers of IOs recast at the same time. Fitch pointed out that performance on these pools will be particularly hard-hit by recasts. If observed IO performance results in higher than expected loss estimates for Fitch-rated RMBS, this may result in further negative pressure on long-term ratings and/or Recovery Ratings (RRs).

Fitch Ratings Managing Director Roelof Slump said "60-day delinquency rates have risen over 250% in the 12 months following previous recasts for prime and Alt-A loans,' said Slump. Even though Fitch's current ratings consider the risks of upcoming IO recasts, 'mortgage pools with significant interest-only loan concentrations may be downgraded if performance is worse than anticipated."