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Extension protection in low FICO pools

| October 12, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

For borrowers with poor credit scores, time tends to lead to faster rates of default, housing turnover or cash-out refinancing. The poor credit either leads to missteps, or the credit improves enough to give the borrower more flexibility. Either way, it’s potentially good news for investors buying related pools at a discount, especially in 30-year 4.0%s.

Initial call protection gives way to extension protection

Exhibit 1 (below) compares prepayment speeds for low and high FICO loans. The S-Curves are built using Fannie Mae and Freddie Mac’s loan level data. The population includes fixed 30-year loans originated in 2013 and newer with original LTVs between 70% and 80% and loan sizes between $200,000 and the base (not jumbo) conforming limit. Each S-Curve represents one year of seasoning.

Exhibit 1: Low FICO pools offer both extension and early call protection

Source: Fannie Mae, Freddie Mac, eMBS, 1010data, Amherst Pierpont Securities

In the first year low FICO loans clearly prepay slower when in-the-money. The GSEs charge a very high upfront loan-level price adjuster (“LLPA”) for low FICO loans. For example, a borrower with a 670 FICO score taking out an 80 LTV loan has to pay 2.75 points (in addition to any other LLPAs that apply). Using a 5x multiple implies a 55 basis point reduction in rate incentive. This elbow shift make the S-Curve look flatter.

However, in the second and third year low FICO loans have started to prepay faster in the out-of-the-money scenarios. After making one to two years of payments many borrowers’ credit scores will improve, boosting mobility and increasing the ability to do a cash out refinance. On the other hand, some borrowers will struggle and eventually default; Freddie Mac’s pool data indicates that buyout rates can reach 0.5 CPR to 1.0 CPR on low FICO pools. Both of these factors lift discount speeds.

In the fourth year the two S-Curves look very similar, although the low FICO loans continue to prepay a little faster out-of-the-money and now look slightly faster in-the-money as well. Some of the convergence is due to burnout in the higher FICO loans, which flattens their S-Curve.

Low FICO pool payups are a good value

Low FICO collateral tends to trade at very low payups, making it an inexpensive source of better convexity. Currently 4.0%s trade with almost no payup and 4.5%s with a roughly 3 tick payup. The theoretical value of the payup is estimated by dialing Yield Book’s new model (version 21.4) to replicate the historical S-Curves on low FICO collateral—slower refinances initially, faster out-of-the-money speeds with a flatter S-Curve in years 2 and 3, and finally a slightly faster S-Curve with a similar shape in years 4 and beyond.

Exhibit 2: Low payups for low FICO pools look cheap (as of 10/10/2018)

Source: Yield Book, Amherst Pierpont Securities

The 4.5%s are trading at roughly 40% of theoretical value, suggesting they are inexpensive. The 4.0%s are even more interesting, since the theoretical payup is higher than on 4.5%s. This suggests that much of the value from these pools comes from the extension protection. Meanwhile the market payup is actually lower on 4.0%s, making them an especially good value if rates continue to move higher.

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