With the structural changes that took place in the Ginnie Mae sector since 1990, these securities have started to look more and more like subprime MBS from a credit and prepayment perspective, said analysts. GNMAs have also become a good alternative for investors looking for call protection as defaults have made them less prepayment- sensitive.

In a recent report, Bear Stearns examined discount GNMA prepays both on an absolute basis and versus their conventional counterparts since 1989, looking at the four periods with the highest interest rates, stable prepays and the largest number of discount MBS. Results show an ongoing trend of faster GNMA discount prepays across all vintages since 1990.

Analysts compared the 1989 and 1990 discount GNMA seasoning curve to Fannie Mae's over the same time period. They found that GNMA prepays were significantly slower compared to conventionals in 1989 and 1990, which started to change in the 1990s.Bear Stearns also compared the discount GNMA seasoning curves to their FNMA counterparts for the three major periods of high interest rates and stable prepayments during the 1990s (1994 to 1995, 1996 to 1997, and 2000).

"What we find is that although GNMA MBS still paid slower than their conventional equivalent in the initial one and a half to two-year seasoning period, beyond that point GNMA discount speeds were significantly faster than their conventional counterparts," analysts wrote. Currently, this pattern remains with moderately seasoned GNMA discounts paying an average of three CPR faster compared to FNMA, while 2004 vintage GNMA discounts pay slower versus FNMA. The only exception to this pattern happened in 1994-1995 vintage when California's housing recession heavily dampened prepays in the California-heavy sector. This allowed GNMAs to prepay faster compared to conventionals across the whole WALA spectrum.

The key in understanding this structural change in GNMA prepays over the 1990s is to study what happened to the GNMA program in this period. Aside from the significant market-share decline, there was a steady rise in seriously delinquent GNMA borrowers - something not evident in conventionals - thus pushing the average GNMA credit profile closer to subprime.

Aside from these factors, the increase in prepays caused by defaults since the 1980s has also played a crucial role in defining GNMA discount prepay behavior in the past two decades. Bear Stearns estimates that GNMA defaults contribute up to four CPR to the baseline prepay rate.

"Layering in the additional four CPR from delinquency, defaults and servicer buyouts sheds some light to prepayment issues, particularly as to why GNMAs have been so fast relative to conventionals," said Dale Westhoff, senior managing director at Bear Stearns. The firm is currently incorporating this default curve in GNMA valuations, he added, because GNMAs are default-driven and tend to be less prepayment-sensitive, which adds more stability to overall cashflows.

Analysts said that the prepay pattern established in the 1990s - slower initial speeds and increases with seasoning versus FNMA - will likely persist and become stronger in the coming months, adding value to moderately seasoned GNMA discount cashflows versus conventionals. Furthermore, in the future analysts will look into the subprime market for insight into future prepay and credit-performance trends in GNMAs.

"In many ways, GNMAs have already assumed a performance profile that is linked to that in the subprime world: a fast base-case prepayment speed with a less negatively convex prepayment profile relative to the conventional sector (although GNMA call risk still remains much higher than that found in the subprime sector)," said analysts.

FICOs as an indicator

In studying the convergence between GNMA and subprime, analysts have discussed whether a borrower's FICO score is actually a reliable indicator of future credit performance. The problem is that even with the credit convergence of the two sectors, FICO scores of GNMA borrowers remain higher than those in the subprime arena. Westhoff added that he has received several inquiries about this issue.

Mark Adelson, a director at Nomura Securities International, said that there have been some instances in the past where FICO scores have not been a reliable indicator of future credit performance. A good example of this is the case of Champion Mortgage in which borrowers performed better than expectations that were based on their FICO scores. He added that the likely explanation for this was how these loans were originated, which involved visiting borrowers at their homes to determine their actual situation.

Adelson said that the FICO scores do not usually capture some crucial information that may affect the borrower's ability to pay. It does not reflect how much money the borrower makes or how much he has in the bank. He said that when mortgage lenders actually make a loan, they look at three important factors to gauge the risk of a loan: the borrower's capacity to make payments, collateral and credit history.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

http://www.thomsonmedia.com http://www.asreport.com

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