Lehman Brothers analysts recently examined the effect of slowing home price appreciation on prime MBS, concluding that these pools will suffer from higher severities and experience lower prepayments under this scenario.
Even though the pace of home price growth has been robust nationally over the past decade, Lehman analysts report there have been differences in regional home price growth - 3% in the worst quartile versus 15% in the best quartile, allowing analysts to draw meaningful conclusions about prime mortgage performance in a slowing housing market.
Defaults on prime pools in a 3% home price appreciation market are roughly double the levels seen in 15% home price appreciation areas. As the cushion from built-up equity lessens, Lehman analysts said the loss severities in such environments could rise to over 25% from the current 10%, although analysts expect cumulative losses in a 3% appreciation scenario to be still less than triple-B subordination levels.
Prepayments on prime pools should slow in a 3% appreciation environment. Base-case speeds on prime pools could go down to 3% to 4% CPR as price growth slows down, analysts said. Refinance activity is also slightly less in such an environment, they added.
Lehman found that weaker credit borrowers are generally more sensitive to the housing market than their prime counterparts. The extent of the absolute change in both prepayments and defaults are significantly higher for borrowers with lower FICO, higher LTV or limited documentation. Analysts also said that trends in spread at origination or SATO could be misleading. SATO, used as a credit indicator, on weaker credit prime pools has tightened considerably recently, driven mainly by secondary market demand for such pools and not improvements in underlying borrower credit. The percentage of higher LTV borrowers, limited documentation loans, investment properties, as well as purchase loans have all increased a lot in recent years, added Lehman analysts. Not surprisingly, such borrowers are more sensitive to slowing appreciation. Although rating agency subordination levels are comparatively higher, the prime pool price growth sensitivity has increased over the years and not lessened as SATO trends indicate.
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