By the Numbers
That ticking sound could be a 40-year FHA loan mod
Brian Landy, CFA | July 16, 2021
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.
Prepayment speeds in Ginnie Mae MBS could jump if the FHA were to introduce a 40-year loan modification into its approach to loans coming out of Covid-19 forbearance. Ginnie Mae lately announced it would allow securitization of 40-year loans starting in October, suggesting a 40-year mod may be under consideration. If servicers have to offer a 40-year FHA mod before other loss mitigation options, servicers could be forced to buy a sizable set of delinquent loans out of MBS. It is not certain, of course, that FHA will offer a 40-year mod or that it would come early in the loss mitigation waterfall. But the biggest impact would fall on 2016 through 2020 vintage pools with 3.5% and higher coupons. The amount of principal returned to investors could reach 10% to 20% of the outstanding balance in many of these cohorts.
The FHA on June 25 introduced a new loan modification program, known as the Advance Loan Modification (ALM). Servicers are required to evaluate all borrowers that leave Covid-19 forbearance for the ALM and offer an ALM to all borrowers that qualify. This must be done before considering other loss mitigation options like the FHA’s payment deferral program, known as a partial claim. Loans that receive a partial claim do not need to be bought out of their pool, but loans that are modified must be bought out. The ALM adds delinquent interest, taxes, and insurance to the unpaid principal balance of the loan, changes the note rate to the current value of Freddie Mac’s Primary Mortgage Market Survey (PMMS) rate rounded to the nearest one-eighth, and re-amortizes the loan over 30 years. Borrowers qualify if the principal and interest payment is reduced by at least 25%. A detailed discussion of the program is available here.
The FHA may be planning to offer a 40-year loan modification. Many additional borrowers will qualify for a loan modification if this becomes part of the ALM program (Exhibit 1). The top section shows the percent of each Ginnie Mae MBS cohort’s UPB that would qualify for a loan modification with a 2.875% note rate and 40-year term, while the middle section uses the same note rate and a 30-year term. Borrowers are assumed to use the maximum amount of Covid-19 forbearance. The bottom section of the table shows the difference between the two scenarios—the increase in eligibility if the FHA were to introduce a 40-year ALM.
Exhibit 1. A 40-year Advance Loan Modification
Only borrowers in premium pools or seasoned pools qualify for an ALM with a 30-year term, although the reach of the program would increase if interest rates fell to 2.75% or lower. But it is easier for a borrower to achieve the required payment reduction using a 40-year ALM. Most loans in 3.5% and higher coupon pools would qualify, even pools issued as recently as last year. The biggest change is to 2016 and newer vintage pools with coupons 3.5% and higher, and those cohorts have the greatest UPB at risk of buyout.
For example, loans in 4% coupon pools receiving a 30-year ALM must have been originated before 2015 to qualify. But with a 40-year modification the largest effect on 4% coupon pools is to the 2019 vintage—13.5% of that vintage could be bought out at par.
However, a major obstacle to a 40-year modification is the lack of a market for Ginnie Mae MBS with maturities longer than 30 years. Servicers are required to buy out modified loans from pools at par, and this capital is raised by selling the modified loan into a new Ginnie Mae MBS. Therefore, pricing is critical since the servicer needs to receive at least par. And servicers need the sale to exceed par to cover operating costs. This is typically achieved when selling a 30-year loan modified to the 30-year PMMS rate. But a 40-year loan modified to the 30-year PMMS rate might trade at a discount, a risk made larger since there is not a liquid market for 40-year Ginnie Mae MBS. This would be a disastrous scenario for servicers that would not have the capital to make up the difference.
Servicers could try to avoid creating 40-year modifications if they are forced to implement the program and if pricing for these loans is poor. For example, the FHA has made the ALM extremely simple to process and offer to borrowers. However, servicers could make the modification sound confusing and suggest that a better alternative exists, hoping borrowers would reject the modification.
It is also possible that the FHA will create a 40-year modification but not incorporate it in to the ALM. The potential increase in buyouts would vanish If a 40-year mod came after the partial claim in the post-Covid waterfall and would reduce the number of 40-year modifications performed. This would benefit investors and servicers.