March 27 (Bloomberg) -- Many analysts and public officials have said that foreclosures of subprime adjustable-rate mortgages would soar this year as owners' monthly payments jumped when interest rates reset to a higher level.

Not only is that unlikely to happen, this year's resets of earlier vintages of subprime mortgages may even reduce some payments that increased in 2007.

The reason? The index to which many ARMs are tied is the six-month London inter-bank offered rate, or Libor, and that rate has fallen from more than 5.3 percent last fall to about half that level.

The Federal Reserve's cuts in its target for the overnight lending rate -- the last to 2.25 percent on March 18 -- from 5.25 percent in mid-September, plus actions to increase liquidity in the inter-bank lending market, have caused the Libor to fall.

Unfortunately, most of the defaults and foreclosures that have wreaked havoc in financial markets haven't been due to resets so far. Many borrowers simply bought a house or condo they couldn't afford unless bailed out by rising prices, and lower rates alone won't help them much.

Still, the big drop in Libor means there likely will be many fewer foreclosures than there would have been.

Much of the discussion about the danger of resets has focused on the initial interest rate, or ``teaser rate,'' that ARMs carried. That left the impression it was a very low rate that would adjust up a lot. Most of the initial rates were 8.5 percent or above, and now many are set to adjust hardly at all.

New Subprime Report

A new report, ``Understanding the Securitization of Subprime Mortgage Credit,'' by economists Adam B. Ashcraft and Til Schuermann of the New York Federal Reserve Bank, published this month, provides a wealth of detail about subprime mortgages. Much of its information is based on a pool of such mortgage-backed securities issued by New Century Financial in June 2006.

All but 12 percent of the loans in the pool were ARMs, either the so-called 2/28 or 3/27 variety. That is, they carried a fixed-initial rate for two or three years, respectively, so the former will first reset in June.

The average initial rate for the loans was 8.64 percent, set when the six-month Libor was 5.31 percent, according to the report. It was a teaser rate in the sense that once resets began, the interest rate would be based on Libor plus a spread of 6.22 percentage points.

Rate Changes

Thus the initial rate was 2.89 percentage points lower than the full rate of 11.53 percent. Had Libor not come down, the reset in June would have raised the monthly rate to 10.13 percent, and the second, in December, would have lifted it to 11.53.

The lifetime cap on the mortgages averaged 15.62 percent, while the floor was 8.62 percent, only 2 basis points lower than the initial rate.

Now, if six-month Libor remains close to its recent level of about 2.6 percent, the June reset would be less than a quarter-percentage point. If the Fed's lending rate target is lowered again, as many investors expect, the loans' interest rate might dip a couple of basis points to the floor of 8.62 percent.

Equally important, 2/28 loans originated in 2005 or earlier whose rates reset to a higher level last year may now be coming down if they are tied to the same Libor index and the spread is similar to those in the pool described in the New York Fed paper.

Ashcraft and Schuermann calculate that if the Libor index had remained unchanged, the monthly payment on a $225,000, 2/28 ARM would increase by 14 percent in the 25th month and another 12 percent in the 31st month.

Less Payment Shock

However, the payment shock would have been greater for a majority of the borrowers, because many loans were 30-year loans to be repaid on a 40-year amortization schedule, while others had an interest-only option for the first five years. In both cases, the unpaid balance was always higher than if the principal was to be repaid over 30 years.

If a borrower's initial monthly payment on a $225,000, 2/28 loan was equal to 40 percent of his income -- and six-month Libor hadn't come down -- resets would have raised the debt service ratio to almost 53 percent in the 31st month.

On an interest-only loan, it would exceed 58 percent at that point, the paper said.

``Without significant income growth over the first two years of the loan, it seems reasonable to expect that borrowers will struggle to make these higher payments,'' the two economists wrote, assuming no decline in Libor. ``It begs the question why such a loan was made in the first place.''

The Question

In all probability, the lenders expected that the borrower would be able to refinance before it was time for the payment to reset, they said.

Refinancing, of course, presupposed that housing values would rise, or at the least not fall a lot, and that's not what has happened.

The question now is how many borrowers can afford to keep making their payments even in the absence of resets, and how many will be willing to do so if the mortgage balance is much greater than the current value of their home.

(John M. Berry is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: John M. Berry in Washington at jberry5@bloomberg.net

Last Updated: March 27, 2008 00:01 EDT