As nine more people were arrested in New York last week in the fraud scandal surrounding the HUD-sponsored 203(k) federal home ownership program, several MBS market participants following the story admitted a surprising realization: they were not fully aware that Ginnie Mae I pools had such an extensive exposure to these loans until news of the fraud broke.

In fact, several investors and analysts were alarmed to learn that some Ginnie Mae bonds - which are supposed to be backed by pools that are made up of a diversified set of assets - are in fact made up of pools backed by a single issuer.

"Frankly, I did not know that these kinds of programs, with undiversified borrowings, are going into Ginnie Mae pools," admitted one MBS researcher. "That means you don't have diversified assets here, you only have one loan. If the whole pool goes bad, you're in trouble. This was news to me when I read it, and it puts a bad light on the whole government loan market. HUD has to answer to investors."

"I would say that most investors were unaware about this," noted another MBS player who wished to remain anonymous.

"In terms of investor awareness, I would not expect investors to be looking out for something like this," said Glenn Boyd of UBS Warburg/PaineWebber. "There is issuer-specific risk here, but even more risk if you buy from an originator where all loans are originated by one company. The prepayment numbers that came out during the fraud case was a surprise to a lot of people. I'm sure Ginnie Mae received a lot of phone calls."

The fraud surrounds the 203(k) program, which is one of HUD's programs to rehabilitate distressed properties in disadvantaged neighborhoods. In the New York case, the suspects allegedly tried to defraud the program by purporting to sell brownstones in Harlem and other poor New York neighborhoods to charitable organizations.

The 203(k) loans are made at above-market rates, and as dollar prices get higher, the temptation of servicers to buy them out at par grows. This high rate of servicer buyouts has significantly increased the prepayment speeds of Ginnie Mae premiums.

"A lot of investors are unaware that there are so many 203(k) loans in the Ginnie I program and there is effectively a lack of diversification as a consequence," said David Montano, director of MBS research at Credit Suisse First Boston. "Many of these loans are controlled by a single entity which can either refinance them or default. And this servicer buyout situation will only get worse."

Servicer Buyouts

In the fraud case, M&T Bank bought out the fraudulent loans from New York-area banks, and all the loans went delinquent on the same date. Some of the pools prepaid extremely fast: 100 constant prepayment rate (CPR) for 1999 GNMA 8.5s and 75 CPR for 1998 GNMA 8.5s; 2000-print 8.5s paid at 52 CPR.

The 203(k) loans are lump buyouts due to non-profits going bankrupt; sources say that M&T had no idea that there was anything wrong with the loans originally.

"Why are these pools TBA-eligible?" asked another MBS participant. "Additionally, a lot of these loans are either multifamily or home-improvement loans, rather than purchase or refinancings. The program has been around for awhile but has grown quite a bit since 1996, and there has never been a real focus on the lack of diversification."

Part of the problem is that HUD/FHA, and certainly Ginnie Mae, have very little control over the servicer buyouts. Although the GSE doesn't have control over the servicers to regulate them, HUD has some say in the matter, a source noted. "This is really an investor issue, but Ginnie Mae should be addressing this because it is going into Ginnie Mae securities," said a trader. "This information is not out there yet, so HUD or Ginnie mae should give more information about which loans are 203(k) just to comfort investors.

While UBS Warburg's Boyd noted that investors are not overly concerned about future fraud, he said that this incident highlights the massive impact that the servicer buyouts could have on the Ginnie Mae market.

"It's a question of prepayment risk in these pools," Boyd said. "Ginnie Mae could change its pooling requirements, but the question is whether investors are happy taking in pools that are backed bye a single issuer. If not, they could try Ginnie Mae II pools, which are multi-issuer. This incident is having an effect, but I'd say it's a one-off event."

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