With Fannie Mae now buying 40-year mortgages, it will not be long before those loans end up in securitizations. In response to this, Lehman Brothers analysts put 40-year mortgage collateral under the microscope and looked at how those loans would likely perform in securitized pools.

In the report, Lehman compares 40-year loans to the other increasingly popular mortgage affordability product, IO loans. Both are structured to reduce monthly payments, with the IO loan offering greater monthly savings at the front end since there is no principal amortization component, as with the 40-year.

Most lenders layer on additional weighted average collateral charges of 25 to 40 basis points for IO loans and up to 15 basis points for 40-year loans. Lehman demonstrates, given a 25 basis point add on for an IO loan and a 15 basis point add on for a 40-year loan, the IO reduces monthly payments by 9.1% while the 40-year reduces monthly payments by 5.4% versus standard 30-year loans. Given a zero basis point add on, a feature many lenders have begun offering, the 40-year loan becomes even more advantageous and the difference between it and the IO becomes negligible.

Though the IO would appear more attractive, Lehman notes that most lenders have stricter restrictions on who can take out an IO, versus a 40-year loan. The 40-year is expected to become the next stop on the mortgage ladder for non-IO qualifying borrowers.

One concern about 40-year loan is that it has potentially higher loss severities due to the slower amortization schedule. The difference in the two amortization schedules is greatest after 30 years, when roughly 68% of the initial principal balance of the 40-year loan is still outstanding. However, that gap should have a limited effect on loss severities because 70% of losses in ARMs occur over the first five years of the loan. Since the amortization gap at month 60 between a 30-year and a 40-year loan is only about 2%, Lehman expects overall severities of 40-year loans to be only marginally higher - 1% to 2% - versus 30-year loans.

The larger risk factor is the potentially higher default frequencies, due to payment shock effects when interest rates reset. As an example, a 7% 2/38 hybrid, with a 6% margin and a 2.3% initial rate cap would experience a 27.3% payment shock versus a 23.3% shock for a 2/28 hybrid. The difference seems marginal, however, as Lehman notes that borrowers with higher leverage and relatively lower credit characteristics than IO borrowers are likely to self-select into 40-years.

(c) 2005 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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