MBS backed by Alt-A mortgages can offer an attractive alternative to regular conforming or jumbo mortgages, said a report by Nomura Securities International named A Journey to the Alt-A Zone. It is a situation "where credit risk and prepayment risk combine in a special way," said report author Mark Adelson.

The report said that compared to regular mortgage loans, Alt-A mortgages are less prepayment-sensitive in the first nine to 12 months after origination, especially in a low- interest rate environment. Previously, Alt-A mortgages even offered greater prepayment advantage, but as the primary mortgage market becomes more efficient and GSEs make inroads into the sector, this advantage has decreased somewhat.

Nomura also discussed two defining characteristics of Alt-A mortgages: less than full documentation and non-owner occupied properties. The report said that the current lender-driven, reduced-documentation process for origination loans will probably produce less risky loans from a credit perspective compared with the borrower-driven environment of the late 1980s and early 1990s.

Adelson explained that many of today's reduced documentation loans are a result of a lender-driven process and not a borrower-driven one. He added that some of today's loan-underwriting processes actually offer reduced documentation to the most credit-worthy borrowers automatically, even if borrowers do not request it.

This is contrast to the late 1980s and early 1990s, when only borrowers who specifically sought reduced documentation loans received them. Adelson said that loans received through this process are arguably riskier due to an incremental risk that the borrower has something to hide. He added that Alt-A pools have a somewhat bigger percentage of borrower-driven, reduced-documentation loans compared to regular loan pools.

Aside from the "basic Alt-A advantage," which is the temporary suppression of refinancing activity, there is also the relatively new practice of separating Alt-A loan pools into groups that have specific loan attributes. Adelson said that this allows investors to fine-tune their strategy when using Alt-A MBS to mitigate prepayment risk in their portfolios.

"The opportunity for investors to target specific Alt-A attributes through segmented loan groups is reminiscent of specified-pool trading in the agency MBS sector," wrote Adelson. "There, investors can express preferences for low loan balance pools and for pools with concentrations of loans secured with properties in slow refinancing states.' "

He added that the only apparent disadvantage of segmented Alt-A loan groups is the possibility of there being comprised of a small number of loans. Adelson said that investors who buy securities backed by small numbers of loans should expect some prepayment volatility. "If two or more loans are prepaid in a single month, the one-month CPR of such a pool can be extreme," he wrote.

However, Adelson says that investors can diversify their exposure to prepayments by buying securities from multiple deals. The overall prepayment speed that investors experience on their Alt-A holdings in such a case would only be the weighted average of the speeds across all positions.


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