With discount GNMAs continuing to prepay faster than conventionals, analysts are starting to incorporate the different factors driving the accelerated speeds into their models.

Bear Stearns, for instance, has included the impact of higher GNMA default rates as well as a steeper default ramp. Analysts layered a modified conditional default rate (CDR) ramp into their prepayment model to duplicate the effect of high defaults and servicer buyouts. These changes will be available on Sept. 20, the firm said.

"Prepayments that are due to defaults are a much larger component in discounts because there's less refinancing there," said Dale Westhoff, senior managing director at Bear Stearns. He added that as one goes up-in-coupon, refinancing plays an increasingly important role with today's GNMA borrower refinancing into conventional fixed-rate product, hybrid ARMs or interest-only loans.

Bear Stearns said that the "abnormally large prepayment contribution coming from defaults" adds 4 CPR to the baseline prepayment rate of GNMAs. This is compared to only 1 CPR in the conventional sector.

In the report, Bear Stearns went to great lengths to detail the effect of the heightened default rate on the seasoning profile of GNMA securities. Analysts noted that although it usually takes 30 to 36 months for defaults to season, the ability of a GNMA servicer to buy out seriously delinquent loans significantly "front-loads" the prepay effect. Prepayment seasoning usually lasts roughly 10 months, compared to 36 months for defaults. It is much longer for defaults because it takes about 12 to 36 months for a loan to go from becoming seriously delinquent through foreclosure, REO and the final stage, a charge-off. The length of these stages change depending on various factors including state foreclosure laws. Non-Agency subprime loans, on the other hand, take roughly 18 months to be charged-off.

Although not as important as defaults, there are some other noteworthy factors that are driving GNMA discount speeds. Rising home prices, for instance, have allowed many GNMA borrowers to move into conventional financing, thus removing the 50 basis point FHA mortgage insurance premium. Furthermore, there are also other alternative products such as the hybrid IO that have appealed to low-income GNMA borrowers.

In last week's Mortgage Strategist, UBS analysts wrote, "Our regular readers know that we've been touting GNMA-to-FNMA refis as the most likely explanation for fast GNMA speeds." This hypothesis was tested even further when analysts used geographic speed breakdowns on GNMAs to evaluate how speeds vary depending on home price appreciation, ARM production, home sales and delinquencies. Results showed that GNMA 5s and 5.5s speeds were much faster for states and vintages with stronger house price appreciation. Moreover, the difference between GNMA and FNMA speeds also increased in line with home prices.

UBS researchers theorize that strong home price appreciation not only creates the opportunity to refinance into conventional loans but also effectively increases the incentive to refinance by 60 to 70 basis points. Analysts also emphasized that fast GNMA discount speeds are not caused by home

sales or ARM refinancings. Delinquencies are also considered merely a minor contributor to speeds, as they only become important in a major sell-off.

In the next couple of months, UBS expects prepayments to accelerate, and GNMA speeds to increase a little less versus conventionals. However, longer term, GNMA speeds are expected to remain fast compared to FNMAs for the foreseeable future since home price trends usually change slowly. In fact, based on the analysis as well as the surprising strength in home price appreciation showed by Freddie Mac's home price index for the 2Q04, analysts predict that GNMA speeds will remain elevated for more than a few months.

Investor's perspective

Michael Cheah, a portfolio manager at AIG SunAmerica Inc., said that despite the current accelerated prepayments in GNMAs, "there's no temptation to switch" to Freddie Mac or Fannie Mae securities. "My clients are more interested in the explicit guarantee found in GNMAs and are comfortable to let me deal with the prepayment problem," he said.

Cheah said that he prefers avoiding higher coupons and has invested heavily on GNMA 5s, citing the recent announcement of Ginnie Mae authorizing the buy out by issuers of GNMA loans from pools affected by the recent storms and hurricanes (see related story on p. 17). Additionally, GNMA premiums are the coupons that are most affected by this development, so by investing in GNMA 5s, this announcement by Ginnie Mae would not be a big issue. Also, by investing in lower coupon GNMAs, Cheah said, "If I buy a discounted security and get paid at par then I'm happy."

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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