Prepay protection at a steep price in high LTV pools

| April 26, 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.

Investors should be cautious when investing in pools of newly originated purchase loans with loan-to-value ratios between 95% and 97%. These loans do offer some prepay protection similar to others such as low FICO and state housing finance authority (HFA) loans. But pricing on new high LTV loans looks extremely rich, and LTV may no longer be a significant barrier to refinancing.

The prepay protection is extremely expensive

Price premiums to TBA for specified pools are high right now, and high LTV pools have recently traded at extremely rich levels (Exhibit 1). Pay-ups for high LTV FNCL 4.0% collateral are more than 160% of the model’s theoretical value, with 4.5% collateral at nearly 115% of theoretical. Most specified pools tend to trade well below theoretical. Even high LTV 3.5% pools are priced at 60% of the model, which is still much higher than usual.

Exhibit 1: High LTV pay-ups are high

Note: all market levels are as of 4/25/2019 COB. Source: YieldBook, Amherst Pierpont Securities.

High LTV pools complete with low FICO pools and 100% HFA pools and all offer roughly similar prepayment protection—very flat initial S-curves that steepen as the loans season. Low FICO loans cure and 100% HFA loans eventually earn forgiveness of the second lien that discourages refinancing. High LTV pools, however, have diminishing barriers to refinancing. Their current prepayment profile is typical of lower pay-up stories, so current price levels for high LTV pools look rich.

New high LTV loans are primarily made through special programs

The relative value of high LTV loans may seem clear with some background.

One source of high 95% to 97% LTV loans are the state housing finance authorities. However, the best prepaying loans from these agencies typically have a second lien that is used to assist the borrower with the down payment. These liens often require no payments and are forgivable after 3-to-5 years; this gives the borrower a strong reason not to prepay the loan. These loans tend to be pooled together as 100% HFA pools.

Other high LTV loans come through Fannie Mae’s HomeReady® and Freddie Mac’s Home Possible® programs. These programs are geared towards lower income borrowers who cannot make a 5% down payment. Most loans pooled in 95% to 97% LTV pools likely come from these programs. An advantage for these borrowers is that loan-level pricing adjustments or LLPAs are capped, but this limits the prepay protection that high LLPAs might offer investors.

High LTV loans traditionally have prepaid very slowly

In the past, loans with high LTVs have had a difficult time refinancing, especially after depreciation. Depreciation can raise the cost of refinancing as the borrower may need to add mortgage insurance (MI) or increase MI coverage (and cost). Enough depreciation could prohibit a refinance entirely. This was especially true after the financial crisis; the HARP refinance program was designed to correct these problems.

Loans originated after May 2009, however, were unable to use HARP, which included loans that had refinanced through HARP. Since loans could not re-HARP, they tended to prepay very slowly until there was enough appreciation to permit a standard refinance. HARP expired at the end of 2018, so these loans are no longer being originated.

Home price depreciation no longer prevents refinancing

In November 2018, the GSEs implemented new refinance programs for loans originated after 10/1/2017 with LTV above 97%. Loans must have at least 15 months of seasoning, cannot be HARP refinances, and must offer some benefit to the borrower such as reducing monthly payment or lowering the interest rate. Unlike HARP, loans refinanced under these programs can refinance under them more than once.

Given the wide availability of this program, new loans with high LTVs that experience depreciation shortly after origination will have at most 15 months of protection from refinancing.

LTV LLPAs don’t increase the cost of a refinance

The GSE loan level pricing adjustments are upfront charges that a borrower must pay to compensate the GSEs for increased credit risk on their loan. The core grid is driven by the LTV of the loan and the credit score of the borrower. In general lower LTVs and higher FICO scores result in a lower LLPA.

However, once the LTV exceeds 80% the LLPA remains relatively unchanged for a given FICO score. For example, a 740 FICO borrower pays 50 bp for an 80% LTV loans and 75 bp for a 97% LTV loan. That is merely a 25 bp increase and, assuming a 5× IO multiple, only results in a 5 bp reduction to the borrower’s rate incentive to refinance. Similarly a 680 FICO borrower pays 175 bp for an 80% LTV loan and only 150 bp for a 97% LTV loan.

The reason the LLPA stays roughly unchanged is that the borrower is required to add mortgage insurance for higher LTV loans. The GSE doesn’t need to charge a significantly higher LLPA since the insurance policy should cover most of the additional credit risk for exceeding 80% LTV.

Furthermore, most 95% to 97% LTV loans have their LLPAs capped under the HomeReady and Home Possible programs. Therefore these loans have even lower prepay protection.

Mortgage insurance doesn’t increase refinance costs, either

Since these loans have high original LTVs the borrower is already paying for mortgage insurance. This is not a part of the note rate of the loan, but instead is generally charged as a percentage of the outstanding balance of the loan and paid monthly in addition to principal and interest.

Consider the options facing a borrower that initially has a 97% LTV loan:

  • Depreciation—the borrower, after seasoning, will qualify for the high LTV refinance option and retain the existing mortgage insurance policy after a refinance.
  • No depreciation—the LTV on the loan comes down, so a subsequent mortgage insurance contract would be no more expensive than the current contract.

In both cases mortgage insurance does not provide disincentive to refinancing. In fact, with enough home price appreciation the borrower could save significant money by refinancing in order to cancel mortgage insurance.

Historical S-curves are initially flat but steepen with appreciation

High LTV loans do prepay slowly initially, but the S-curve tends to steepen pretty quickly as the loans appreciate. Exhibit 2 shows S-curves for loans in three different bands of original LTVs with 5% and 20% cumulative HPA. The highest LTV loans start off with a much flatter S-curve, but after 20% appreciation look quite similar to the 70% to 80% LTV loans with similar appreciation. In other words, a 97% LTV loan that appreciates to 77% LTV prepays similar to a 75% LTV loan that appreciates to 55% LTV.

Exhibit 2: High LTV S-curves start flat but steepen over time

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

The S-curves were developed using 2014–2016 vintage loans, which predates the introduction of the new high LTV refi option programs. It is possible that this program could cause S-curves to steepen more quickly at lower levels of appreciation.

The 90% to 95% LTV bucket shows the danger posed by home price appreciation, which pushed these loans faster than the 70% to 80% LTV loans. These borrowers can have significant incentive to prepay to eliminate mortgage insurance. High HPA could eliminate the prepay protection very quickly.

john.killian@santander.us 1 (646) 776-7714

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