The Federal Housing Finance Agency (FHFA) announced a new streamlined loan modification program last Tuesday.
Loans that will come under the program include those of high-risk borrowers who have missed three payments or more, occupy their residence, and have not filed for bankruptcy.
FHFA Director James Lockhart stated that the program creates a fast-track method for modifying a first mortgage payment to "no more than 38% of the household's monthly gross income." The program's goal "is to create a more affordable payment."
This will be achieved through various means such as reducing the mortgage rate, extending the life of the loan, and deferring payment on part of the principal, he said.
What impact this might have on mortgage-backeds is currently uncertain. For example, a report from JPMorgan Securities analysts said that it is unclear how much of the outstanding universe can participate. One of the questions that analysts asked is whether the program will include loans that are in existing pools, or is it only going to apply to loans that are directly held by Fannie Mae/Freddie Mac or loans in bank portfolios? The analysts said that it will likely apply to all loans, whether pooled or not.
Another question was if the loan were modified, would it be removed from the pool, thus creating a prepayment? "According to current servicing guidelines, Fannie and Freddie are required to buy out any loans prior to modification," Barclays Capital analysts noted in a report.
With this new plan, Barclays analysts believe the GSEs are likely to become more aggressive in the near future in buying out delinquent loans. The GSEs have been inactive in this process since late last year, because they have turned their focus to preserving capital.
With this outlook, prepayment speeds should increase over the near term - particularly for premium securities, the analysts said, although they don't believe overall prepayment volumes will increase by much. However, they warned that the program could give current borrowers an incentive to become delinquent, which could increase prepayments to levels above those analysts are currently expecting.
Arthur Frank, director and head of MBS research at Deutsche Bank Securities, said that "somewhat less than 1% of the loans in Fannie and Freddie MBS pools are likely to qualify for streamlined modifications, somewhere in the range of 100,000 to 150,000 borrowers. That's not trivial but it is likely to have only a modest impact on prepayment speeds." He noted that the exact details of the program have not been worked out and are unclear at this point.
In his research, Frank noted that 90-day delinquencies are now running at 1.57% at Fannie and 1.23% at Freddie Mac.
Frank anticipates that the rise in prepayment speeds should be focused in 2006 and 2007 production premiums, specifically those pools with comparatively high LTVs as well as low FICO scores. High LTV premiums might not offer quite as good a call protection in the future under this modification program, compared with what these pools have provided in the past, Frank said.
In their report, Barclays analysts attempted to quantify the potential impact on speeds if the GSEs decided to quickly buyout delinquent loans. As an example, they calculated that if all the accumulated 90+-day delinquencies are bought out over a three-month period, speeds on 2007 6.5s could spike by 23 CPR, while 5.5s could see an 8 CPR increase. While premium coupons would be hurt by the buyouts, discounts would benefit. They estimated, for example, that for 6.5s, a 6.3% immediate reduction in factor leads to about four ticks of loss in premium securities, and slightly over a tick in 6s.
Aside from prepayments, JPMorgan pointed out that there would also be an impact on loan duration. Analysts said that even if the program were restricted to mortgages held by the GSEs and banks, it would lower the WAC on these loans and cause prepayments to slow.
"If for example the WAC on a FNMA 6.5s is lowered by 30 basis points, it would cause the duration of the bond to extend by 0.3 years," they said. Analysts estimated that for the overall universe, the loan modification program would add $30 billion 10-year equivalents - much of which would be hedged as the GSEs tend to be active hedgers.
Essential Disclosures
The new modification program will require the two GSEs to provide more detailed information regarding delinquencies and buyouts. Buysiders would be able to assess the prepayment risks that are associated with different pools if they had data about these important variables, Merrill Lynch said in a recent report.
GNMA already offers this information on a pool level, and analysts think that investors would actually welcome such disclosure from Freddie and Fannie as well.
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