In a report released recently, Lehman Brothers talked about the product innovation in hybrid neg-am loans.

In the report, analysts looked at the key features of these loans. Lehman said that in the past year, prime ARM supply was largely centered on two very dissimilar products: monthly reset option ARMs and long reset hybrid IOs. Analysts said that this focus is set to change with the emergence of hybrid mortgages with neg-am features. They pointed out that hybrid neg-am mortgages have a better credit profile compared to option ARMs. Furthermore, prepayments in this sector could be slower versus comparable hybrid IOs.

The accrual rate on hybrid neg-am product is fixed for the first few years for 5/1 hybrids.

Similar to regular option ARMs, borrowers have several payment options, such as a low teased payment that might be even less compared to monthly interest. Analysts pointed out that while accrual rates on MTA loans reset monthly, they are fixed for hybrid neg-ams over a period of roughly five years. Thus, the extent of neg-am in a hybrid neg-am mortgage is not subject to movements in short rates but is fully under the borrower's control, analysts said.

They also explained that to offer a cushion against payment shocks, borrowers do not need to make a fully amortizing payment as soon as the neg-am cap is hit. If this happens in the fixed-rate period, borrowers are only required to match the interest payment thereon to prevent the loan from further neg-am. This is why the payment shock on a hybrid neg-am occurs in two stages and, in turn, becomes more manageable compared to the shock in option ARMs.

Analysts added that a 5/1 hybrid neg-am is equivalent to a 5/1 IO with a neg-am option. The duration extension because of the option is not really significant in itself. But analysts said that the potential for neg-am may result in higher LTV over time, and more subordination cost could result in a 35 to 40 basis point higher rate on the product compared with 5/1 IOs.

Increased popularity

Lehman expects hybrid neg-am products to gain popularity with new borrowers and to offer an attractive refinancing opportunity for 5/1 IO and option ARM borrowers. In recent originations, qualification differences have mostly driven product choice. For instance, most purchase borrowers favored IO loans because it is easier to qualify. At the same time, most borrowers who wanted to cash-out took out option ARMs to lessen monthly payments. If the hybrid neg-am product is easier to qualify for than an option ARM because of the lower risk, the product should attract a fair share of both purchase and cash-out refinancing borrowers, Lehman analysts stated.

In a regular option ARM, analysts explained that credit risk is caused by the payment shocks that increase default frequency as well as the higher LTV that increases loss severities. The hybrid neg-am loan soft recast feature staggers payment shocks and helps lower the default frequency. But that self-selection could cause a fairly large proportion of the pool to choose to neg-am and, subsequently, result in high LTVs. Generally, analysts expect the default performance of these loans to be better than that of option ARMs.

Option ARM prepayments have not historically been very sensitive to rates, analysts said. This is because monthly payments on the product are not tied to accrual rates. Low monthly payments offer a strong disincentive to moving into alternative products such as 5/1 IOs, even if accrual rates on such alternatives may be lower. In the same way, hybrid neg-am refinancings are probably going to be influenced by payment incentives, and prepayments are expected to be slower than on typical 5/1 IOs.

Alternative structures

In the report, analysts also highlighted two structuring alternatives based on recent prime MBS deals.

The first one are capped corridor floaters. Option ARM collateral gained acceptance among investors due to the short-reset ARMs being conducive to the creation of Libor floaters. In the same way, capped-corridor floaters off Alt-A fixed-rate collateral have been popular. To make a similar structure off hybrid neg-am collateral, caps should be bought into the transaction over the fixed-rate period. Since hybrid neg-am collateral is probably going to print faster compared to fixed-rates, the resulting cap risk is lower, analysts explained. Thus, such floaters are expected to trade at a tighter DM versus those created off fixed-rate collateral.

When it comes to pass-through structures commonly found in non-agency hybrids, analysts said that pass-throughs off hybrid neg-am collateral could be priced fairly similar to passthroughs off 5/1 hybrid IOs. They could also be at a slightly wider spread to compensate for the neg-am risk.

(c) 2006 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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