With increased prepayment risk, not to mention higher dollar prices, investors should consider passthroughs backed by FHA/VA reperforming mortgages that have been purchased out of GNMA pools, analysts said, as these loans have weathered at least one serious delinquency.

This growing segment of the MBS market offers significant call protection, as the borrower has only a limited ability to refinance given a history of delinquent payments, said a report by Nomura Securities International, Inc.

The report explained that GNMA allows servicers to buy mortgages out of pools that they service at par plus accrued interest if there were no payments that were made on the loan for 90 days or if the mortgage has one payment delinquent for at least 120 successive days. These reperforming loans can be re-pooled if the servicer is able to get the borrower to make payments on the loan. Specifically, it becomes a reperforming loan' when at least three monthly payments in the last six months have been made.

As a result of their delinquent payment record, borrowers cannot readily take advantage of refinancing opportunities. Analysts said that the poorer the payment history and the farther behind the borrowers are on the payment on their mortgages, the less negatively convex the pool becomes.

Therefore, they have less prepayment sensitivity to interest rates versus comparable GNMA pools, says the report. For example, seasoned GNMA 7s, 7.5s and 8s prepaid at between 25% and 35% CPR in May. This compares to 15% to 20% for reperforming FHA/VA deals that Nomura has been involved in.

Nomura has developed a matrix for estimating the option cost of delinquent FHA/VA mortgages relative to the option cost of GNMA pools with a similar profile. The matrix was developed from observations of the prepayment behavior of these loans in 1998-1999 and 2001-2002 refinancing waves. Nomura said that as the borrower's delinquency status worsens, the option cost dips in a steady manner. For example, it drops to 20% of the option cost for mortgages that are at least 150 days delinquent from 85% of the comparable GNMA option cost for loans that have become current after a serious delinquency

According to the firm, their option cost matrix appears to be a conservative estimate of the relatively strong call protection of reperforming loans.

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