High Cost Fuels Demand for Interest-Only Products.

With recent economic news showing that the U.S. economy is in a steady growth phase, and the Federal Reserve signaling that higher interest rates are a possibility, more consumers are going to look to interest-only mortgages to sustain housing affordability, especially in the subprime IO sector, and it's with these non-agency MBS products that investors may find value.

Although in the marketplace for several years, consumers demanded IO mortgages in a big way in 2004 and 2005 as home prices continued to climb, particularly along the coasts and other high-cost markets. Long-term mortgages inched higher from near all-time loans and more consumers sought the lower payments offered by IO mortgages.

In 2005, between 7% and 8% of the total mortgage market consisted of subprime IO mortgages, or as much as $220 billion, based on data from Moody's Investors Service and MSN surveys.

And while it's too early for a definitive viewpoint on how subprime IO mortgages will perform once their initial interest period expires, a new report by Countrywide Securities suggests that mortgages in this sector have to date performed better than amortizing subprime mortgages.

According to data gathered from Loan Performance, a subsidiary of First American Real Estate Solutions, Countrywide reported that the cumulative 60+ day delinquency rate for subprime IO mortgages originated between January 2004 and June 2005 was about 5%, while the 60+ cumulative delinquency rate for amortizing subprime mortgages was nearly 10%.

While at first counterintuitive, the fact is underwriting standards on subprime IOs are more stringent and may contribute to their better performance to date. For example, Countrywide noted that the FICO scores for average subprime IO mortgages originated in 2004 is approximately 44 points higher than for non-IO subprime mortgages. That spread increases slightly to 45 points through the first half of 2005 at a time when many observers expected credit standards to soften as originators chased after volume.

In addition, Countrywide points out that subprime IO mortgages are "almost exclusively for owner-occupied properties." Investors generally have less stake in a property than owners and this may also contribute to better credit performance of subprime IOs than other ...