With MBS credit currently an issue in the mortgage market, analysts have been focusing more on LTV as a credit indicator. Aside from credit fundamentals, analysts have also studied how LTVs impact MBS prepayments. Although high LTV loans previously prepaid slower compared to lower LTV mortgages, the opposite is happening now (see ASR 10/25/04).
In a recent report, Countrywide Securities stated that the recent uptick in LTVs in the 30-year sector is probably not reflective of a deterioration of credit fundamentals, but it is more an indication of a rise in the percentage of purchase loans over the last quarter. Analysts noted that LTVs have begun to edge higher after steadily declining since late 2000. The report also showed, however, that purchase loan LTVs are consistently higher versus refinancing mortgage loans. Countrywide said this is reflective of the fact that refinancing loan LTVs usually decline as the borrower's property appreciates. The increase in the percentage of purchase loan issuance for most of 2004 is, analysts argue, mainly responsible for the upward creep in new-issue LTVs.
Merrill Lynch, meanwhile, examined the prepayment aspect of LTVs, with a focus on the relationship between LTV and geographic regions. High LTV, low credit borrowers have been prepaying faster, compared to their low LTV and high credit counterparts, Merrill analysts noted, attributing this phenomenon to the desire of marginal borrowers to make monthly payments more manageable and perhaps take cash out through popular hybrid ARM and hybrid ARM IO alternatives.
Merrill analysts singled out Ginnie Mae borrowers as falling almost exclusively in the high LTV umbrella, thus it is not surprising why they are prepaying faster. Within GNMAs, Merrill points out that GNMAs in high home price appreciation states like California and Nevada are prepaying significantly faster compared to lower home price appreciation states like Texas. "Among the marginal borrowers that constitute the GNMA population, the ones who are refinancing quickly are those who have the most home price appreciation and are best able to take cash out and/or refinance," analysts theorize, adding that the only real exceptions to this would be Florida - which has a refinancing tax - as well as Colorado, which they could not explain.
These two points have led analysts to study geographical dependence of conventional loans when separated by LTV buckets, leading to the revelation that LTV dependence is far more notable in states with a high level of home price appreciation - including California - compared to other states. For instance, a low LTV pool in California might not prepay exceptionally fast, but a high LTV one may be notably fast. In contrast, a high LTV pool in Texas is not expected to prepay as fast. In terms of GNMAs, it is important to remember that prepayment behavior is mirrored precisely in the conventional market. In other words, since high LTV conventionals are prepaying fast, so are GNMAs. In the same way that GNMAs are especially fast in California, thus the same goes for high LTV conventionals.
Merrill said that from a relative value perspective, lower coupons with high LTVs from California would probably offer the most value. However, higher coupons with high LTVs from the state would appear to be unattractive.
"While these findings are likely to persist in the near term, they may no last forever," wrote analysts. They added that if the curve flattens further and home prices start to moderate, this phenomenon would probably slowly diminish, noting that if there is a radical drop in home prices or a sharp move in short term rates, the trend might even reverse. This was the case in 1994 when GNMAs prepaid slower versus conventionals and conventionals were slower compared to Dwarfs, which traditionally have lower LTVs
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