Uncategorized

Low balance modified loans offer call and extension protection

| 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.

admin
jkillian@apsec.com
john.killian@santander.us 1 (646) 776-7714

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.

Important Disclaimers

Copyright © 2024 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.

The Library

Search Articles