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Low balance modified loans offer call and extension protection
admin | February 22, 2019
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.
Fannie Mae and Freddie Mac have actively pooled modified loans for years, recently including loans modified into low coupons that have slowly stepped up to a final fixed rate. Although the data are limited, these step-rate mods look likely to show more stable prepayments than generic 30-year pools. They also show prepayments that vary significantly based on loan balance. The 30-year step-rate mod niche trades at slightly wider spreads than competing 20-year and seasoned 30-year MBS and looks like a good opportunity for investors in specified pools.
Fannie created 30 year low loan balance mod pools last year
Fannie Mae has created a number of pools backed by low loan-balance modified loans, while Freddie Mac has created almost none. Many of the Fannie Mae pools are 40-year fixed-rate mod pools, but in 2018 the agency issued large pools backed by step-rate mods. The agency initially modified these step-rate loans under the HAMP program to an interest rate below prevailing mortgage rates. After five years paying the subsidized rate, the loans’ note rates increase up to 1% a year until reaching the rate cap, which equals the market rate at the time of modification. Fannie Mae pools these loans only after reaching the terminal rate so the pools pay a fixed coupon.
Since Fannie Mae modified most of these loans from 2010 through 2012 and usually had two steps, it takes at least seven years for these loans to become eligible for pooling. This constrained Fannie’s ability to create these pools prior to 2018. Moreover, many of these loans have less than a 30-year original term, in contrast to the fixed-rate mods with term extensions commonly well beyond 30 years. Most 30-year mod pools consequently are step-rate mods. These pools compare easily to regular 30-year pools since the payments are on a comparable amortization schedule.
Historical data indicates modified loans have flatter S-curves
Fannie Mae has published data with the historical performance of the modified loans held in portfolio. Performance in this data runs through March 2016. The advantage of this data is that it includes performance on a large number of loans in a variety of rate environments. A disadvantage is that many of the step-rate loans are not yet fully stepped up.
One way approximate the S-curve when the loans are fully stepped up is to only consider the performance of loans that are approaching or in the step-up period. At that point, borrowers are likely comparing refinance opportunities to the terminal rate of the loan and not to the current subsidized rate; rate incentive should be calculated against the future interest rate the borrower will pay. Exhibit 1 (below) compares S-curves for modified loans to similar-vintage generic loans.
Exhibit 1: Modified loan pools had slightly flatter S-curves in 2018
Source: Fannie Mae, Freddie Mac, eMBS, Amherst Pierpont Securities
Fannie Mae grouped its modified pools into three different buckets based on loan size at time of modification: ≤$125,000; $125,000 to $175,000; and >$175,000. The analysis here grouped the non-modified loans in the same way,rather than the traditional LLB, MLB, HLB or similar cuts. All of the modified loans have at least four years of seasoning since modification.
All three S-curves show a similar pattern—the loans prepay faster when out-of-the-money, and in-the-money prepay similarly or a little slower. Therefore modification improves the S-curve of even the smaller loans.
Exhibit 2 (below) uses the same S-curves but compares them across loan balances to make it easier to see that that lower balance modified loans have a flatter S-curve than higher balance modified loans.
Exhibit 2: Modified loan pools had flatter S-curves as loan size decreases in 2018
Source: Fannie Mae, Freddie Mac, eMBS, Amherst Pierpont Securities
Fannie Mae’s pools have prepaid consistently with the historical data
It is possible to conduct a similar analysis using the pools Fannie Mae has issued. The data is fairly limited since most of the pools were issued in April and August 2018. Furthermore it will take some time for default rates on the loans to ramp up; data from Freddie Mac pools suggest these loans will reach 1.5–3.0 CPR from defaults. Therefore out-of-the-money speeds are likely lower than long-term levels. Exhibit 3 (below) recreates Exhibit 1 using these pools’ performance and compares to that of seasoned generic pools in 2018.
Exhibit 3: Modified loans have flatter S-curves, regardless of loan size
Source: Fannie Mae, eMBS, Amherst Pierpont Securities
The results are broadly consistent with the data from Fannie Mae’s historical dataset, with modified loans prepaying faster out-of-the-money and slower in-the-money, regardless of loan size. However the smallest loans have prepaid much slower than comparable fixed rate loans
Similarly Exhibit 4 (below) compares the same S-curves by loan type to illustrate that lower balance loans have flatter S-curves regardless of whether or not they were previously modified.
Incidentally, the S-curves for seasoned generic pools clearly illustrate the benefit of smaller loans in a higher rate environment. The ≤$125,000 loans prepay roughly 2.0 CPR faster than the >$175,000 loans when they are more than 50 bp out-of-the-money.
Exhibit 4: Modified loans have flatter S-curves as loan size decreases
Source: Fannie Mae, eMBS, Amherst Pierpont Securities
Conclusion
Seasoned loans that were previously modified tend to have favorable prepayment performance across different rate environments compared to similarly seasoned loans that were never modified. This benefit carries over to smaller loans, which already have favorable prepayments compared to larger loans. Therefore low loan balance modified loans have the potential to offer investors even more prepayment protection than typical low loan balance loans.
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