With mortgage rates increasing, extension risk is once again in the forefront of MBS investors' minds, said Citigroup Global Markets analysts. A way to gain extension protection is to purchase collateral with nonstandard characteristics, such as a high LTV or a low FICO score. In the past, loans with these characteristics were seen as credit impaired and associated with slower speeds. But since the GSEs began releasing pool-level LTV and FICO data, the market started believing that "credit-impaired" collateral could provide extension protection in certain cases.
The firm's analysis supports the extension protection properties of high-LTV and low-FICO collateral. The researchers focused on the interaction between FICO and LTV, and on how these characteristics seem to magnify each other's influence on out-of-the money speeds. The main thing to takeaway from this study is that both high LTV and low FICO lead to faster discount speeds, specifically in strong housing markets, and that these two together offer better extension protection than each does apart. In the article, analysts refer to pools with a FICO below 700 as low-FICO pools, and to pools with a FICO above 700 as high-FICO pools. Pools with the original LTV above 80% are referred to as high-LTV pools, and pools with the original LTV below 80% as low-LTV pools.
Citigroup analysts asked: Which characteristic, FICO or LTV, is mostly responsible for faster out-of-the money speeds? For a lot of cohorts, low-LTV, low-FICO collateral was faster than those with high LTV and FICO, although this was not universal. Analysts think both characteristics lead to faster speeds, with the FICO effect perhaps slightly stronger, especially for new collateral.
The impact of WAC and loan size was also highlighted. In terms of WAC, neither low FICO nor high LTV alone imply a higher WAC, but pools with both characteristics present will have a WAC higher by 15 to 30 basis points, analysts said. This implies that low-FICO, high-LTV borrowers are offered higher mortgage rates compared to traditional agency borrowers. Borrowers, who have one but not both characteristics, are subject to the same mortgage rates as traditional agency borrowers.
In terms of loan size, high-LTV borrowers have lower loan sizes. This may be a sign that high-LTV borrowers are less affluent and perhaps younger compared to their low-LTV counterparts. Both factors tend to lead to higher mobility, analysts said. FICO scores seem to have no relationship to loan size. Meanwhile, the geographic distribution of low-LTV and high-LTV collateral is slightly different. The main distinction is that high-LTV collateral has a relatively low California concentration. FICO score has a smaller impact on geography, analysts added.
Faster discount speeds of low-FICO collateral are explained mostly by low-FICO agency borrowers' similarity to subprime borrowers, particularly the higher propensity to cash out equity. This also plays a role in fast speeds of high-LTV collateral, although high leverage and home price appreciation also help younger and more cash-constrained high-LTV borrowers to trade up, analysts explain.
The reasons behind faster discount speeds imply that high-LTV, low-FICO borrowers are more leveraged to the housing market, and this may have lessened their role in mitigating extension risk, analysts said. To better understand high-LTV, low-FICO collateral's leverage to the housing market, analysts considered two questions: How likely is it that high-LTV, low-FICO collateral will experience a housing downturn, and how strongly might this downturn affect discount speeds?
The first question has to do with concentration in states with robust housing markets, such as California. Since high-LTV collateral has a smaller California concentration, such paper is less likely to have a more modest housing downturn compared to low-LTV paper.
In terms of the second question, analysts estimated that speeds of pools with both high LTV and low FICO are almost twice as sensitive to home price appreciation as generic low-LTV, high-FICO pools. The sensitivities of pools with only one nonstandard characteristic fall about halfway in between, they said.
Although high-LTV, low-FICO collateral is likely to prepay slower in response to a less robust housing market, analysts believe that in most scenarios, short of an extreme housing downturn, discount high-LTV, low-FICO collateral will prepay slightly faster compared to generic low-LTV, high-FICO collateral.
A way for investors to lessen this leverage to the housing market, while at the same time still having some extension protection, is to purchase loans with only one nonstandard characteristic. Picking low-FICO pools might be the better alternative because, in many cases, the extension protection remains very meaningful, Citigroup analysts said. But low-LTV, low-FICO pools typically have high California concentration, and while these features contribute to faster speeds, they also mean prepayments slowing if California's housing market weakens. The other possibility is that of buying high-LTV, high-FICO collateral. However, this offers only slight extension protection versus generic pools even if there is a smaller California concentration, said analysts.
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