Market participants should pay attention to FICO scores even if they are above 700 and command no pay-up, Deutsche Bank analysts said in a recent report.
In a largely discount mortgage universe, superior carry is derived from faster prepay prints. And those who diligently look through their inventory and identify characteristics that are associated with higher turnover speeds usually get rewarded, Deutsche analysts said. Although the specified pool market has always emphasized seasoning, loan size and credit scores are important determinants of discount turnover speeds as well. In the study, analysts started by sorting the outstanding FNMA 5s into 10 equal size buckets from fastest to slowest and according to June 2006 CPR prints. The fastest bucket has the lowest original credit score (OCS) - which is typically FICO - and the lowest average original loan size (AOLS). However, it does not have the highest WALA. Repeating this same exercise for FNMA 4.5s and 5.5s basically gives the same result. In short, the combination of low OCS and low AOLS seems to produce the fastest prepayment print for the discounts, even though the OCS for the fastest bucket tends to be only five to 10 points lower than that of the rest of the buckets and well above 700.
Analysts give different reasons behind such extension protection. They noted that slightly lower OCS borrowers are young borrowers who are not yet stable and who thus need to relocate frequently. They also may be, to a certain extent, so-called "perpetual borrowers" with chronically maxed-out credit cards who refinance to cash-out another $15,000 every time their house appreciates $20,000 in value. To a lesser extent, they could also be "precarious borrowers" that fall into delinquency and are eventually forced to either default or sell their house. Analysts lean towards the first explanation, and think the second and third explanations are probably more relevant for extension protection offered by OCS less than 700 FICO borrowers.
Analysts concluded that all else being equal, they think slightly lower OCS is an undervalued source of extension protection provided by borrowers who are inherently more mobile. Researchers urge investors to pay close attention to the FICO scores of the pools they own, even if they are over 700 and command no pay-up. On the other hand, investors should make sure that they are not getting specified pools that are adversely selected for other characteristics. The slightly lower FICO benefit could easily be compounded by other variables.
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