Though Freddie Mac's new modifiable mortgage offering will provide lenders with a solution to bottlenecks associated with heavy refinance activity, analysts say that these products - which carry more prepayment risk - would trade significantly behind TBA securities and would never achieve the liquidity of the TBAs.

Freddie's new product would provide homeowners with an alternative to the refinancing process, the GSE says, by offering a fixed-rate home mortgage that can be modified after it is sold to Freddie Mac. It would be pooled under one of two designated guarantor PC prefixes.

The modification option, available for newly originated and seasoned loans, will be available to customers on a negotiated basis. This offering will only allow downward modifications to the borrowers' note rate and monthly payment.

MBS analysts say that if this new offering is priced aggressively enough, it could look very attractive for consumers because it is only a loan modification - there will be no need for the accompanying hassles and hurdles of going through the whole underwriting process, such as verifying one's income or having one's property reassessed.

Investors' point of view

However, despite the apparent benefit to consumers, modifiable loans would be seen as a prepayment by investors, and that is where the crux of the problem lies. MBS analysts say that for this offering to work, homeowners would have to be charged a higher interest rate than the going rate, which is totally different from how conventional loans are priced.

Originators can turn around and sell conventional products into the TBA market at par and also collect servicing and origination fees. However, if lenders were to offer modifiable mortgages they would have to sell the bonds at a discount in the secondary market. Lenders, in effect, will make less money with these modifiable mortgages relative to what they would have gotten on a regular conventional loan.

"How much more homeowners will be charged depends on where these things would trade in the secondary market," said an MBS analyst. "So that's why it's really a trade-off between investors' estimate of the prepayment risk versus homeowners' estimate of how much they are going to save when they opt to modify their mortgage."

He added that there would be a huge amount of uncertainty among investors about the amount of prepayment risk involved, so they will probably prefer to err on the conservative side, and price for the worst case.

In a UBS Warburg report, analysts stated that, "it remains to be seen whether homeowners will be willing to pay up (in the form of higher rates) to avoid the hassle and cost of a refi."

Some mortgage strategists said that investors would mostly likely feel that they would have to be paid a whole lot more than the homeowner is willing to pay. Many doubt that this program will emerge as the next big product, comparable to the 30-year fixed-rate mortgage.

"I think it would be an interesting product to see, assuming that they could generate enough origination to have some meaningful prepayment history and to see how these things prepay; that will give you a real read on how prepayment speeds depend on refi efficiency," said an MBS observer. "Though that would be interesting to see, I don't think anyone expects this product to take off and be the next 30-year mortgage. It's probably going to be a non-issue for the secondary market."

BMA's response

These securities will not be TBA-eligible. The products have been segregated into new sub types: the pools of these mortgages will be designated with prefixes "MM" and "MN", for 30-years and 15-years, respectively. This was done, sources said, to protect the integrity of the TBA market.

In a release, Freddie officials said that with this distinction, they do not "expect prepayment rates in these prefixes to affect the market calculation of overall prepayment rates in any other Freddie Mac PCs."

Separately, according to officials from the Bond Market Association (BMA) - which worked with Freddie Mac to make sure that the proper distinctions were made - the prefixes protect investors because the disclosure helps them anticipate the level of prepayments in pools with modifiable mortgages.

Not only does the increased disclosure help investors but it "also gives our dealers the ability to properly analyze the securities before they sell them," said Robert Fry, director of fixed income operations at the BMA. "The dealers' reaction was positive to the new product and to the kind of notice that Freddie Mac provided to us. They are happy with having the ability to work with the new product and with having the notice necessary to work it into their systems and their analysis tools."

However, Fry said that until there is volume in this product, it's difficult for them to answer the question of how popular the product would be.

Lenders' perspective

Mortgage lenders, sources said, were the ones who pushed for the product, in a bid to retain loans.

"You don't want someone to refinance your Wells [Fargo] loan and take out a GMAC loan," said an MBS analyst.

Analysts say that lenders are always looking for ways to make consumers happy. This is why they had put pressure on Fannie Mae and Freddie Mac to come out with the streamlined refinancing product, for instance.

In the same light, the development of the modifiable mortgage is also a way to reach more consumers. Many borrowers would rather modify their loans than go through the process of refinancing. Though streamlined refinancing comes close, it still requires consumers to do a re-application, to provide some documentation, and to spend for closing costs.

"Lenders are always looking for products to have in their back pocket," said Robert Segal, a portfolio manager at J William Mantz Investment Advisors LLC. "Every little bit helps in such a competitive market. You can't have enough products."

The fact that 1/1 ARMs were very popular in the late 1980s proves this point. During this time, Fannie developed a convertible product that allows borrowers to convert a 1/1 ARM to a 30-year fixed at no cost.

If one looks at the numbers, this convertible product was less effective than a refinancing. Further, 1/1 ARMs have not stood the test of time as a popular mortgage product. Despite the fact that these products did not last, they were able to provide lenders with a competitive advantage.

Subscribe Now

Access to a full range of industry content, analysis and expert commentary.

30-Day Free Trial

No credit card required. Access coverage of the securitization marketplace, including breaking news updated throughout the day.