Report Shows Difficulty for High SATO Volume

New York-While high spread-at-origination borrowers cured quickly during 2005-07, they can no longer do so in the current environment due to dramatically tightened underwriting, sharply widened mortgage credit spreads and weakened economic conditions, according to "The Secret of Seasoning," the latest prepayment outlook report from Barclays Capital.

Much slower speeds of 2005 and earlier vintages were mostly driven by their higher spread-at-origination, a result of lower prevailing mortgage rates during 2003-05.

Strong home price appreciation and easy access to mortgage credit during 2005-07 probably prompted many 2003-05 borrowers to take out silent second liens or home-equity lines of credit.

This may have also contributed to their slower speeds, the report said.

One thing that puzzled the research team in the latest prepayment report was the extent to which 2005 and earlier vintages prepaid slower than newer production, as some may have expected the lower LTV in seasoned loans to allow them to better take advantage of the historically low mortgage rates than newer production of FNMA and FHLMC 30 year pools by origination year.

The 2003-05 vintages prepaid about half as fast as newer production. This behavior was dramatically different from the 2003 experience when seasoned pools provided nearly no call protection.

Based on Freddie Mac's limited loan-level data, the research at Barclays Capital found spread at origination (SATO) to be highly correlated with FICO, LTV, debt-to-income ratio, loan purpose (cash-out or purchase), occupancy, property type, documentation and the number of borrowers on the loan.

The aforementioned factors along with a ballooning non-agency mortgage market led to a very quick curing process for high SATO borrowers during 2004 to early 2007. This is because credit spread narrowing presents more refinancing opportunities to high SATO than to low SATO borrowers, according to Barclays Capital.

It is also because credit-impaired borrowers are generally more leveraged to HPA and the economy and benefit more from a booming non-agency market.

While the same factors continue to drive speeds of high SATO borrowers today, the effect has reversed. Since the second half of 2007, mortgage credit spreads have widened sharply. As a result, a borrower who took out a loan in 2003-06 with a 50 bp SATO may be charged a 150 bp SATO today when trying to refinance even if the credit profile has remained unchanged or improved slightly.

This has taken away refinancing opportunities from many high SATO borrowers. Since the 2003-05 productions have a higher SATO than the 2006-07 vintages, their ability to refinance has been impaired more severely.

Meanwhile, the significantly negative HPA, deteriorating economy, and near complete shutdown of the non-agency mortgage market have also made it much harder for high SATO borrowers to cure or refinance. Over the next few quarters, this trend should continue as long as HPA remains negative, the economy stays weak, and mortgage credit spreads persist at wide levels.

While President Obama's Homeowner Affordability and Stability Plan could take some of the LTV and FICO constraints away, many other factors that contribute to a higher SATO, such as the significantly weakened HPA and economy and sharply widened credit spreads have made it much harder for high SATO borrowers to cure now.

As the team detailed in a prior report, the burnout effect of seasoned pools works only to a certain point. Specifically, this effect diminishes as the prevailing mortgage rates become increasingly attractive by historical standards. As the rate attractiveness in 2003 reached all-time high (even to this date), the burnout effect of seasoned pools almost evaporated completely.

Some of the 2003-05 loans may carry silent seconds or HELOC loans, making it harder for them to refinance.

Another factor that may have played a role in the slower seasoned speeds is the booming HELOC market during 2005-07.

When HPA was strong and mortgage credit plentiful, many borrowers tapped into their home equity by taking out a silent second mortgage or HELOC, as suggested by a ballooned second-lien/HELOC origination during 2005 to early 2007.

Logically, a borrower tends to take out a HELOC after seeing some appreciation in home value. This suggests that most of the silent seconds and HELOCs taken out during 2005-07 were by borrowers who took out their first-lien mortgages during 2003-05. On the other hand, the 2006-07 production first liens had not much home price appreciation before the HELOC market shut down in late 2007.

Consequently, while the LTV of the 2003-05 agency production are generally lower than those of the 2006-07 vintages, their effective combined LTV taking into account silent seconds and HELOC may not be much lower.

While SATO was the dominant driver of the much slower speeds in seasoned vintages, it is important to note that other factors, such as smaller loan size and burnout, also played a role albeit to a smaller extent.

Over the next few quarters, the Barclays Capital outlook predicts that seasoned collateral should continue to offer call protection, although investors in this sector should closely examine the spread-at-origination of individual pools.

Even for newer production (2006 to early 2008), high SATO pools should offer substantial call protection for a modest pay-up.

In other news relating to prepayments, the University Financial Associates Repayment Risk Index for the first quarter of 2009 registers 79, hovering near 80 for the fifth quarter in a row.

Under current conditions, UFA says lenders should expect mortgages originated this quarter to repay at a rate 21% below earlier vintages if interest rates remain constant.

Repayments include only voluntary repayments by borrowers, while total prepayments are defined as the sum of defaults and repayments.

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