With the IO product expanding its market share significantly, analysts expect it to overshadow other affordability products, specifically the 40-year mortgage. As a result, there is now increased attention on the prepayment performance of IO collateral, as evidenced by UBS starting a new section in its weekly report about the prepayment outlook on agency and non-agency hybrid IOs, with analysts noting increased investor interest in and demand for the collateral.
In a recent report, Credit Suisse First Boston also noted that fixed-rate IO mortgages are starting to make up a more significant portion of the origination and issuance mix, likely to overshadow the 40-year mortgage - a new entrant in the affordability products playing field - which Fannie Mae began purchasing on June 1. Fixed-rate IO product directly competes with the 40-year mortgage since borrowers who self select into fixed-rate mortgages would more likely compare these two products, according to CSFB.
"We expect this product to remain a niche offering," said CSFB analysts of the 40-year option, adding that the product's amortizing loan growth could be hampered by the lack of TBA delivery option, which is the same for IOs, although IOs provide relatively substantial monthly payment savings. Aside from this, the significant increase in IO FNMA 5/1 issuance reflects the fact that IOs hybrids are no longer a purchase-only product, but are also seen as a refinance vehicle. "This follows on the heels of an established presence of IOs in the jumbo hybrid sector, where they come to represent the benchmark," analysts wrote.
CSFB analysts also point to the fact that IOs have contributed to the growth in certain sectors, specifically in 10/1 hybrids. Currently, the 10/1 IO monthly payments are lower than that on amortizing 5/1 and 3/1 hybrid loans. At current rates, and assuming that there is no difference in IO relative to amortizing primary mortgage rates, a 10/1 borrower's monthly payment on a $500,000 mortgage is $425 lower for 5/1s and $385 lower for 3/1s.
Meanwhile, due to increased investor inquiry, UBS has begun to study IO agency and non-agency hybrid prepayments through a dedicated column in its weekly report. Analysts also noted the increase in IOs in agency pools, which now make up about 45% of hybrid issuance in Fannie Mae 3/1s, 5/1s and 7/1s. Increases are primarily in 5/1s and 7/1s, as IOs comprise more than half of new hybrid issuance for Fannie Mae. UBS noted that Freddie Mac is playing catch up in terms of IO exposure, as it recently added new programs to securitize these types of loans. Freddie announced earlier that initial interest adjustable rate mortgages would be available for sale under its WAC ARM cash and WAC ARM guarantor executions on or after July 1, which is expected to spur IO ARM securitization thru Freddie's program.
"We only see the trend in IO originations continuing, as borrowers take advantage of payment incentives in the increasingly flat yield curve environment," UBS analysts said. Although they have not yet presented a comprehensive analysis of agency hybrid IO speeds, analysts expect speeds on agency IOs to be a bit slower versus amortizing counterparts.
In non-agency product, UBS analysts report that prime non-agency IO issuance dropped slightly in 2005, with more borrowers choosing option ARMs. New issuance in prime IO ARMs as a percentage of total prime ARMs dropped to 38% this year from 61% in 2004, according to analysts. In terms of prepayments, analysts think that borrowers who have locked in low IO payments have less incentive to refinance out of their current mortgages. Many of them are utilizing IOs as an affordability vehicle, with some stretching to buy a bigger house and many unable to refi out of their current loan.
One of the problems with studying IO loan prepayment behavior is the lack of historical data. Specifically, Countrywide Securities report that longer-term prepayment data on IO ARMs are very limited, which is typical of new loan products. The market is currently mispricing IO hybrids versus amortizing ARMs with comparable characteristics, such as weighted average life, margins and caps. However, early prepayment data suggests that speeds on IO hybrids are slower prior to the reset, making the floating-rate tail both larger and longer post-reset, which is very valuable to investors.
Currently, the market is pricing IO hybrids as if their cashflow and prepayment characteristics made them less valuable than amortizing ARMs. Countrywide believes that with investors potentially receiving more of the valuable floating rate coupon after reset, IO hybrids should be priced to tighter spreads versus amortizing ARMs, rather than wider, as they are currently being valued.
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