NEW YORK - At the Bear Stearns' Mortgage and Structured Products Conference 2005 held here last week, analysts expressed concern about whether the influx of new affordability mortgage products has created artificial borrower demand, making lower credit borrowers more vulnerable in a rising rate scenario.
Senior Managing Director Dale Westhoff said that there are three recent major changes in the mortgage market: record home price growth, expanded access to credit and the growth of new affordability mortgage products such as hybrid ARMs and interest-only mortgages. Some of the consequences of these changes, he said, are the fastest discount speeds on record and a shrinking and fully amortizing fixed-rate universe.
The ARM product has become a "vehicle to home ownership," Westhoff said, noting that the dramatic rise in ARM share of originations started in 2Q03 and has since "cannibalized" the traditional 30- and 15-year sectors. A considerable percentage of ARM production is in IO loans, a trend first seen in California and is being mirrored by the rest of the country.
In his presentation, Westhoff showed that declines in affordability have been largely offset by utilizing interest only mortgages. IO loans currently make up a significant percent of today's hybrid ARM production. He noted that to achieve the same monthly payment reduction via a standard 30-year mortgage, rates would have to fall 300 basis points (see chart). Westhoff, however, warns that lower monthly payments come at the expense of building equity. Because of this, borrowers become vulnerable not only to payment shock but home price declines as well.
The problem is these affordability products started in the prime arena, and more recently have gravitated in huge numbers to the lowest part of the credit spectrum. Westhoff noted that approximately 85% of subprime mortgage product is in some form of ARM product, mostly IO ARMs. Clearly, these new alternatives have allowed a whole new segment of the borrower population to qualify for higher cost loans. However, the reset risk is "front-loaded" because the lowest credit borrowers usually only qualify for the shortest rate reset products. This problem is compounded by the fact that 2005 should be a non-refinance environment, and will be characterized by thinner subordination
levels and less deleveraging than previous years.
With the advent of these new products, conventional wisdom in the mortgage market was challenged in 2004, as there were a few aberrations seen in prepayment behavior. For instance, discount 30-year MBS prepayments were faster compared to 15-years, GNMA speeds were faster than conventional counterparts, expanded criteria loans were faster than prime loans and FNMA MBS prepaid faster than Golds. These trends are expected to continue for roughly the next six months.
In the case of the 15-year sector, for example, Westhoff said that it has become more self-selective than before because traditional 30-year borrowers who would have chosen to refinance into this sector, are now moving into ARMs or other alternative products instead. Ginnie Mae market share has been affected as well. With home price appreciation and a lot more options open to these borrowers, Ginnie Mae has become a lender of last resort. One factor causing this is that Ginnie borrowers are charged with a 50 basis point annual insurance premium for a minimum of five years. Thus, many have refinanced out of a Ginnie mortgage to avoid paying these premiums. Recently, The Bond Market Association suggested changes to the Agency's insurance program rewarding refinancers with clean credit histories (see ASR, 1/10/05).
Westhoff also discussed extension risk in the mortgage market in 2005, which he said would be driven by home price appreciation, purchase loan concentration and the fixed-to-ARM refinancing incentive. He stated that home price growth drives discount prepayments, explaining his point by presenting state-level data on prepayments and home price growth. The data showed that the states with higher appreciation also experienced faster prepayment speeds.
Purchase loans have more extension risk compared to refinance mortgages, added Westhoff. This is because purchase loans have no tenure, cost more and have little accumulated equity. In this discount environment, Westhoff said that his firm likes expanded criteria loans, GNMA collateral, the 2003 vintage, relocation loans and hybrids.
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