In recent research, Lehman Brothers analysts examined the effect of FICO on prepayments. They concluded that low FICO pools display faster discount prepayments, which is driven by their greater sensitivity to house price appreciation, and, to a lesser extent, by higher defaults. Low FICO loans are also less callable, although the difference narrows over time. Analysts also found that FICO adds some useful information when predicting prepayments beyond what the spread at origination (SATO) offers.
Lehman said that low FICO borrowers are usually income constrained and are expected to be comparatively young, implying a higher mobility and greater sensitivity to home price appreciation. This is why in a strong housing environment, these borrowers usually take advantage of the accumulated equity in their homes comparatively sooner either in the form of cashout or a trade-up. Analysts also noted that a lackluster economy would mean more financial pressure on low FICO borrowers compared to their higher FICO counterparts, thus leading to a higher default rate. Another factor to consider is that since low FICO borrowers are comparatively younger, and because it takes awhile to build a good credit history, they would have a higher mobility and turnover rate.
Analysts also added that defaults played a minimal role in explaining turnover differential across FICO. They stated that defaults pick up as FICO drops, with the effect most pronounced at the backend of the seasoning curve. However, this could not explain much of the turnover differences.
Lehman also looked at the fact that low FICO pools are less callable. Low FICO pools have a lower propensity to refinance compared to high FICO pools in a market rally. This lower tendency to refinance is partly because low FICO borrowers - who have less lending alternatives - have higher refinancing thresholds, at least in the beginning. Furthermore, low FICO borrowers are probably going to be less sophisticated in their personal finance choices, which would mean less responsiveness when presented with a refinancing incentive. However, the difference in refinancing propensity becomes less over time, a narrowing that is mostly driven by burnout.
Credit curing is also a factor in premium prepayment convergence. Credit curing not only depends on loan age, but more importantly, on the level of home price appreciation experienced over the life of a loan. This is why analysts are expecting a faster curing process in recent years, considering the record high home price appreciation seen.
"While differences in callability across FICO converge over time, the default differential, on the other hand, does not seem to converge," Lehman analysts wrote. "As such, the relationship between FICO and premium prepayments may actually invert for a very seasoned pool."
Finally, researchers looked at the FICO and its relationship to SATO and discovered that FICO adds information beyond what SATO could offer for both turnover and refinancing. Analysts looked at the portion of prepayments that is not explained by their non-agency prepayment model. The model seemed to under predict discount prepays for low FICO pools, which is a clear sign that FICO has some additional predictive power for turnover beyond what SATO could provide. Though less clear, the analysis also shows that FICO has some impact on refinancing, even after controlling for SATO.
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