Principal Reduction Plan Should Have Minimal Prepayment Impact

In its prepayment commentary, "Securitized Products Weekly," Barclays Capital says it does not believe the recent initiatives announced by the Treasury Department will have a material effect on agency prepayments.

"The HAMP enhancements apply to loans that are delinquent or in danger of imminent default, the same loans that would eventually have been bought out anyway," the analysts write.

According to Barclays, the net effect of the new FHA refinancing option, if fully implemented, will be a 2-4 conditional prepayment rate increase for 6.5s and less for lower coupons.

In the "Mortgage Market Comment" from the research and analytics department at Barclays Capital, analysts expect minimal direct prepay impact and moral hazard is a risk.

While allowed, they say it's important to note that principal forgiveness has not been extensively used as a modification tool under HAMP until now.

"The addition of principal mods at the top of the HAMP waterfall will have minimal direct impact on agency MBS prepays since delinquent loan borrowers would be bought out anyway," said author of the report Mukul Chhabra.

"Moral hazard is an important risk that could have the unintended consequences of a large number of underwater borrowers defaulting to benefit from the plan," according to Chhabra.

"This would increase cost to taxpayers and potentially disrupt the MBS market through prepayment spikes."

Post buyouts, Barclays estimates that about 12%-13% ($600-650B) of GSE loans left in MBS pools will be underwater with about 41% of this amount having more than 115 current LTV.

In the report, Chhabra writes that 10%-15% of the above underwater loans should already be in some stage of delinquency and are likely to get bought out in the coming months.

An additional 15%-20% of underwater loans are likely to become delinquent over the next year based on expected roll rates, he said.

"Using principal forgiveness as a major policy tool for modifications potentially exposes the remaining 70%-75% of underwater loans to strategic default risk," noted Chhabra.

"Even if principal forgiveness is restricted to underwater loans with 115 LTV, there is default risk on up to 3.3%-3.8% of incremental GSE loans ($167 billion-$192 billion). In fact under the current HAMP terms, a loan does not even have to default to qualify for a mod.

"An imminent risk of default is sufficient for qualifying a loan for a modification."

He said the actual number of defaults could be even higher in the case of a further decline in home prices or if the LTV threshold for offering principal forgiveness is set at a lower level than 115.

The expansion of the FHA refinancing option carries the potential to significantly increase Ginnie Mae issuance if successful, according to research and analytics at Barclays Capital.

This program would mainly apply to refinancing underwater (but current) subprime, pay-option ARMs, and Alt-A borrowers, since qualifying borrowers in GSE pools would find HAMP a more favorable alternative.

"However, we note that large principal writedowns may dampen servicer participation and the negative credit impact could discourage borrowers. Moreover, the program is not slated to be fully operational until fall.

"We also note that these borrowers required a principal writedown to refi into an FHA loan and as such potentially represent a different credit profile.

"Therefore, TBA eligibility of these loans is questionable and SIFMA may have to address this issue."

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