Forty-year fixed rate mortgages have recently hit the market as another option for borrowers looking for payment savings, but how effective are they? A recent report from JPMorgan Securities set out to answer this question by looking at 40-year, fixed-rate mortgages versus 30-year TBAs. The results - although admittedly limited - were quite surprising.
The report begins by comparing monthly payments on a 40-year mortgage to that of a 10/20 IO and a regular 20-year mortgage. For the analysis, researchers assume a $200,000 loan at a rate of 6.75%, which is the current prevailing no-point mortgage rate. Though it initially appears that 40-year mortgages can increase payment savings, results show otherwise "After adjusting for higher mortgage rates [charged for 40-year mortgages], savings from a 40-year mortgage drops to just 4% (or $27 per $100,000 loan balance). In comparison, an IO loan still would offer a 12% in monthly payment savings," analysts said.
Considering this, JPMorgan analysts sought out to find other reasons why a person might be interested in the 40-year option, and found that the pools have lower FICOs (15 to 20 points lower), lower LTVs (69 versus 74/75) and higher refinancing shares (72% versus 20% to 46%) when compared to 30-year reg-am or IO loans originated in the same period.
The lower FICOs suggest that 40-year mortgages are more like Alt-A, with the lower FICOs mitigated by the lower LTV and higher refinancing shares. "We surmise that these borrowers would have opted for IO mortgages if they had better credit (credit scores on the IO loans are 15 to 20 points higher)," analysts said.
Moreover, the cash flows of a 40-year MBS are likely to be front-loaded, despite the 40-year amortization schedule. For example, at 6 CPR (100 PSA), factor is just 0.08, and at 10 CPR, the factor is only 2%. "Therefore, under most reasonable prepayment scenarios, there is likely little difference between the expected cash flows of the 40-year and 30-year MBS," the report noted.
As for the model valuation data - although there is no empirically based prepayment model that exists for 40-year mortgages - the report extends the 30-year fixed-rate prepayment model to 40-years by averaging the last 12 months' projections in the 30-year model and holding them constant for the next 10 years.
For a slight premium 6.5 coupon, the "baseline" fair value price spread is only six ticks back of TBA (at equal OAS to TBA 6.5), said the report. In fact, for every 10% slower turnover speed, i.e., 1 CPR, the price should widen by three ticks.
On the other hand, if turnover from borrowers prove to be faster than TBAs, price spread should compress considerably. More specifically, the break-even turnover multiplier for a 40-year versus TBA current coupon is 1.2. In other words, for current coupon 40-year MBS to trade flat to TBA, they should prepay 2CPR faster for life.
"At this stage, our main concern is extension rather than call risk," JPMorgan analysts said. "For long-term value, we would prefer 6.5% 40-year pools to 6% 40-year pools."
Barclays report
Barclays Capital also came out with a report on the same topic. The firm noted that the 40-year mortgage grew from only having $19 million in origination in 2005; the product now makes up about 20% of collateral in subprime transactions among the top lenders.
"In the subprime space, in 2006 there has been a shift away from IO lending and into 40-year loans, which are seen as less risky than IOs due to a smaller payment shock," Barclays analysts said. "While the jury is still out on the performance of this product, more and more originators are joining the growing club of lenders that offers the 40- and even 50-year amortization products, particularly to first-time home buyers in high-cost areas."
The majority of these loans securitized in home equity deals are ARMs. Barclays added that a less popular option among borrowers is a loan that has a 40-year schedule for the initial 20 years and then a payment recast to pay off the loan in the subsequent 10 years. In the prime market, some mortgage originators have extended schedules utilizing longer amortization terms like 45- and 50-year terms.
Barclays analysts added that there are more originators marketing the 40-year product. Long Beach Mortgage, WMC Mortgage and New Century Mortgage had the highest concentrations of 40-year loans in subprime deals securitized: 43%, 41% and 28%, respectively. They added that with rating agencies favorable treatment of 40-year loans compared to IO collateral, analysts predict even greater issuance of 40-years versus IO product in the second half of 2006. In terms of performance, analysts said data shows that 40-year product is exhibiting similar performance versus other affordability mortgages, adding that 40-year loans have FICO scores that are between IO and hybrid ARM loans.
"We are not yet convinced that 40-year loans will outperform the IO loans, but [we'll] closely follow the performance and growth of this product in MBS securitizations," Barclays concluded.
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