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Friday, August 17, 2007

Lookback-ward, Angel

by Tanta on 8/17/2007 07:45:00 AM

The question of falling yields on the low end of the curve and ARM resets comes up periodically in the comments. I offer a few UberNerdly tidbits of information about that.

First, review: an ARM adjusts to a rate equal to index plus margin. The index used and the margin, expressed as points, are spelled out in the note, as is the “reset” date. Your note will call this a “Change Date.” There are rate Change Dates and payment Change Dates. In an amortizing or interest-only loan, the payment changes on the first day of the month following the rate change. (Interest is paid in arrears on a mortgage loan.)

The index used will have a “maturity” equivalent to the frequency of the rate adjustments once the loan gets past its initial fixed period (if it has one). A true 3/1 ARM will adjust every year after the first three years, and so it will be indexed to some kind of 12-month money. The 2/28 and 3/27 are so-called to distinguish them from a 2/1 and 3/1; the 2/28s reset every six months after the first two years, not every year thereafter. (This convention is not consistent across the industry, I’m afraid. There are many, many Alt-As out there labeled as 5/1s that are really 5/25s.)

The “traditional” ARM was indexed to constant-maturity Treasuries (CMT). Almost all ARMs with a 6-month reset are indexed to LIBOR, but plenty of loans these days with a 1-year reset are indexed to LIBOR. LIBOR comes in 6-month and 12-month versions, just like Treasuries.

So the note for a 2/28 will say that the new interest rate will be equal to the 6-month LIBOR value plus the margin, usually rounded to the nearest eighth, subject to the adjustment caps, as of a certain date. Most 2/28s have caps you will see indicated as “2/1/6.” That means that the rate cannot go up or down more than 2.00 points at the first adjustment; it cannot go up or down more than 1.00 point at any adjustment after the first one; and it cannot go up more than 6.00 points over the life of the loan. (Unless you’re dealing with a real slimy lender who puts a “floor” on your ARM, so that it cannot go up or down more than 6.00 points over its lifetime. That’s all too common in subprime, but not in Alt-A or prime. The GSEs will not allow “floors” on an ARM: the rate can go down as far as the formula index plus margin can go down.)

The note will also indicate the time that the new index value is established. This is called a “lookback period,” although you will not see the term “lookback” in your note. All ARMs indexed to the one-year Treasury, and some other ARMs, will have a 45-day lookback period, which means that the new index value will be “the most recent index figure available as of the date 45 days before each Change Date.” This 45-day period was established as “standard” back in the old days, when lenders got information about indices from statistical releases published by the Fed on paper and sent out in snail mail; the servicer often didn’t have the “most recent” index value until some point in the month prior to that Change Date, which occurs on the first. But to keep things uniform and fair to the borrower, the value was the one in effect 45 days prior to the change, even if the lender didn’t get that info until two weeks before the change, when it could start updating its index tables on its servicing system (or having Marge in servicing get out the ledger book and a sharp pencil).

Almost all ARMs with a LIBOR index, on the other hand, have a “first business day” lookback. That means that the index value used is “the most recent value as of the first business day of the month immediately preceding the month in which the change occurs.” These notes specify that the source of the LIBOR index is the Wall Street Journal; there wasn’t much of a time delay in getting the WSJ for servicers even back before the internet.

So anybody with an annually-adjusting ARM with a reset date of October 1 will have gotten the August 15 index value. Anybody with a semi-annual ARM (like a 2/28) will get the index value in effect on September 3. In both of those cases the new payment at the adjusted rate will start on November 1.

Margins on prime ARMs are usually 2.75 for Treasury ARMs and 2.50-2.75 for LIBORs. Alt-A is generally 2.75-3.50 or thereabouts; the “risk-based pricing” adjustments will vary by the amount of risk-layering on the loan. Subprime can range from 3.50 to 6.50, again depending on loan quality and other terms.

A 2/28 with a start rate of 8.50% that has its first adjustment on September 1 and a margin of 6.50% will have a “fully-indexed” value of 11.82688 (6 Month WSJ LIBOR on 8/1/07 = 5.32688). Rounded to the nearest eighth that’s 11.875%. Since that is more than the maximum first adjustment cap of 2.00% allows, the rate adjusts to 10.50%. At the next 6-month adjustment, it can go up another 1.00 point. It does not stop going up unless and until it hits a fully-indexed rate of 14.50%, which is the lifetime cap (start rate plus 6.00%).

A lot of the modifications that are going on right now involve servicers taking a look at that 6.50% margin. If, in fact, the borrower did make the first 24 payments on time, there’s an argument to be made that that margin could come down to something closer to Alt-A or near-prime. If you modified the note to bring the margin on the example loan above down to 3.50%, you’d get the rate resetting to 8.875% instead of 10.50%. On a $100,000 loan, that would be a payment of $807.49 versus $924.50. If you made that modification subject to future modification back to 6.50% if the borrower doesn’t perform, you are, possibly, offering an incentive for continued performance. And if the borrower continues to perform, it’s hard to understand why you’d still call it “subprime.” Credit grades are snapshots in time, not prisoner tattoos.

“Normally,” of course, people who take subprime loans and manage to perform for at least 24 months are supposed to refi into a nice cheap prime loan. Now that LTVs are just too high for that, some people are going to have to stay in the loan they’re in. There may only be a few subprime borrowers who fit this case—who have made the first 24 payments on time, can handle an adjustment from 8.50% to 8.875%, and want to continue to own the home—but I’m damned if I can see why we shouldn’t do margin-mods for those few. 350 bps is a fair margin over credit risk-free money for someone who is making the payment every month. Sure, it might mess up your excess spread calculations on your ABS, but foreclosing will mess it up worse.

That said, please note that we’d have to have a miraculous LIBOR rally to help out anyone with a 6.50% margin and an 8.50% start rate: the 6-month LIBOR would have to hit 2.00% on the first business day of the month before the reset date to keep that loan flat. Those nasty neg am ARMs with rates that reset monthly, based on a monthly index, might get some short-term slowing in the rate of negative amortization, but it’ll take a long, long stretch of low short rates to bail those things out.