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Forbearance set to improve convexity, reduce supply

| April 3, 2020

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.

The economic shutdown intended to stop the spread of COVID-19 has caused millions of people to lose their jobs, and the number should grow.  Conventional and government borrowers that lose their jobs can skip mortgage payments for up to12 months without hurting their credit. The potential surge in delinquencies in agency MBS could slow prepayment speeds significantly, by 10% in conventional MBS and close to 20% in Ginnie Mae MBS. But mortgage originators can reduce interest rates to keep their pipelines full, which could increase prepayment speeds on more refinanceable loans. The initial surge in unemployment could also reduce gross MBS supply by 5% to 10% over the next two months by preventing loans from closing, but supply should stabilize once unemployment peaks.

High unemployment improves MBS convexity

Prepayment speeds could slow 10% on conventional MBS and 20% on Ginnie Mae MBS if the unemployment rate reaches 13.5% in June. This is the mid-point of a 12% to 15% range being predicted by many economists. Nearly 10 million workers filed new unemployment claims over the last two weeks, representing roughly 6.25% of the workforce.  This may already be enough to push the unemployment rate to 10%.

Most of these borrowers are likely to stop paying on their mortgages since they have the option to skip up to 12 payments without hurting their credit. The percentage of delinquent loans should quickly jump as high as the unemployment rate. Dual-income families may be overcounted—if both borrowers are laid off it would generate only one delinquency, and in some instances where one borrower remains employed the income may be high enough to maintain payments. But these adjustments are likely to be small.

Unemployment is also more likely to affect FHA borrowers, so delinquencies should jump more in Ginnie Mae MBS than in conventional MBS.  If the unemployment rate reaches 13.5% that could cause conventional delinquency rates to jump 10% and Ginnie Mae to jump 20%. Most of these borrowers are unlikely to prepay—whether voluntarily or through servicer buyout—since they will likely be on forbearance plans. This should lower overall prepayment speeds by 10% in conventional MBS and 20% in Ginnie Mae MBS.

Elevated buyout rates will be a huge risk later in the year and in 2021

 Many of these delinquent loans may not cure, which would result in a spike in prepayments when those loans are bought out. To avoid a buyout, a loan either needs to cure or qualify for the GSEs’ new “payment deferral” program, which permits borrowers that are at most two months delinquent to defer those payments until payoff or maturity. But many loans may require modification or be taken to foreclosure, which could trigger a massive prepayment spike.

At this time Ginnie Mae does not offer a payment deferral program comparable to the GSEs’ program. However, after past natural disasters, Ginnie Mae MBS have proven less susceptible to a spike in buyouts. The majority of Ginnie Mae loans are serviced by non-bank lenders that are unlikely to have the capital to do buyouts, so borrowers are given more time to cure than in conventional MBS.

Supply drops in the short run due to loan fall-out

In the near term, MBS supply could fall by 5% to 10% due to the spike of new unemployment claims. A borrower laid off during the process of purchasing a home or refinancing a loan probably will be unable to close. This could also slow prepayment speeds by a similar percentage, which implies roughly 1 CPR to 2 CPR slower prepayments for the next couple of months. Ginnie Mae MBS should slow somewhat more than conventional.

But in the long run supply remains steady as originators lower interest rates

High delinquency rates reduce the number of borrowers that can refinance, but originators currently have room to lower mortgage rates to maintain origination volumes. Throughout March, originators appeared reluctant to drop mortgage rates below 3.25%, which corresponds to roughly 60% of loans having at least 75 basis points of rate incentive. The most recent Freddie Mac primary mortgage market survey rate was 3.33% and implies a primary-to-secondary spread of roughly 160 bp, about 70 bp above normal. If 20% of borrowers become ineligible to refinance, originators can respond by lowering rates to 3%. It is possible that COVID-19 could reduce capacity more; for example, if a significant number of loans officers were to become sick.  That would reduce aggregate prepayment speeds and primary rates would stay higher.

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