Fixed Income Research

Changes to the Lehman Brothers GNMA Prepayment Model

June 3, 2002
Amitabh Arora 212-526-5751 aarora@lehman.com Vikas Reddy 212-526-8311 vshilpie@lehman.com

We changed our GNMA fixed-rate prepayment model on May 24. This is a structural change to the model and will bring it in line with our Conventional fixed-rate models. This means that main components of prepaymentsturnover and refinancingare modeled in a similar way in the two models. Also, the non-traditional variables used in our Conventional modelloan balance, geography, home price appreciation and SATOare used in a similar way in the GNMA model. Overall, the new GNMA model is more callable than the existing one and shortened TBA durations by 0.1 to 0.5. For the MBS index as a whole, the model change shortens durations by 0.06 years. Given the similarity in structure, the new GNMA model is best discussed relative to the Conventional model. A good place to begin is a discussion of the underlying borrower characteristics.

BORROWER CHARACTERISTICS
Mortgage insurance for the lender is provided by FHA (about two-thirds of the loans) or VA (about one-thirds of the loans) in GNMA pools. The FHA insurance program is targeted at first time home buyers, who are unable to make the standard 20% down payment. Similar to private mortgage insurance, borrowers are charged an upfront mortgage insurance premium (MIP) as well as an annual MIP for the higher credit risk stemming from high LTVs and poorer credit of the typical borrower. Unlike private mortgage insurance, however, the insurance premiums are not risk-based i.e. all qualifying borrowers are effectively charged the same premium.1 The VA insurance, where the eligibility depends on military experience, also allows high LTV ratios. The result is a self-selection of borrowers into the GNMA program, who cannot qualify for a Conventional loan or for whom FHA/VA insurance costs less than private MIP. An analysis of a representative sample of recently originated 30-year fixed-rate loans shows that GNMA borrowers have higher LTVs, lower loan balances (because of lower loan limits on FHA/VA insurance), and a higher share of low income borrowers (Figure 1). Geographically, relative to Conventional pools, the South Atlantic (Virginia through Florida) region is over-represented and California is under-represented in GNMA pools (Figure 2). The higher delinquency rates among GNMA borrowers, where 30-day delinquencies run in excess of 6% relative to about 2% for Conventionals, reflect the poorer credit of such borrowers. Finally, the credit characteristics of GNMA borrowers do not appear to be systematically related to whether a cohort is a par-coupon or premium origination (Figure 3). In contrast, for Conventional loans, credit conditions deteriorate in higher WAC pools as more Alt-A like borrowers

1 The

caveat is that the FHA annual MIP does depend on original LTV, whereby the premium is paid for a longer period by higher LTV loans.

The authors wish to thank Teresa Candido for her helpful comments.

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Figure 1.

Borrower Characteristics for GNMA versus Conventional Collateral, 2000 Originations

GNMA 47 42 Conventional 22 25

Characteristic Low-Income Borrowers % * Underserved Areas % ** LTV 90th Percentile Median 10th Percentile Loan Size Distribution 90th Percentile Median 10th Percentile

100% 98 87

94 79 58

68K 115 176

71K 136 238

* Low income is defined as income less than or equal to 80% of area median income. GNMA refers to FHA only here. ** An underserved area is defined as a census tract with median income at or below 90% of the area median income; or a census tract with median income at or below 120% of the median income areas and a minority population of 30% or greater. GNMA refers to FHA only here.

Figure 2.

Geographic Distribution for 2002 Origination 30-Year 6.5s, %

GNMA 13 4 25 8 13 5 8 3 7 14 Conventional 23 7 17 5 14 6 9 3 5 11 Difference (10) (3) 8 3 (1) (1) (1) 2 3

Region California New England South Atlantic West South Central East North Central Pacific Mid-Atlantic East South Central West North Central Mountain

Figure 3.
WAC Range 6.25-6.75% 6.75-7.25 7.25-7.75 7.75-8.25 8.25-8.75

Conventional Credit Quality Deteriorates with SATO*

Approx. SATO -45 bp 5 55 105 155 LTV GNMA 95% 95 96 96 96 Conventional 74% 74 76 78 80

* For 2001 origination 30-year collateral.

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get mixed in. For instance, during 2001, where 30-year mortgage averaged about 7%, the average LTV increased from 74% bp for low WAC loans to 80% for high WAC loans. In contrast, the LTV averaged 96% for pretty much all the WAC ranges for GNMA loans.

FHA INSURANCE
FHA insurance merits a separate discussion since it has changed dramatically over the last decade, with significant implications for prepayments. There are two components of FHA insurancean upfront piece which has decreased from 3.8% before 1993 to 1.5% in the last round of revision in January 2001. (Figure 4) The upfront MIP is refunded according to a sliding scale if the borrower prepays the loan. Further, an annual MIP of 50 bp was instituted in 1993, which is repealed when the loan, in the course of normal amortization, reaches 78% LTV. The MIP is a significant element of the cost of refinancing and needs to be accounted for because it has changed over time and differs for loans with different seasoning. For instance, since the introduction of the annual MIP, there is a greater incentive for seasoned GNMA borrowers to refinance into a conventional loans once their LTV and credit has improved. Quite simply, such a borrower can save the 50 bp of annual MIP. This has boosted seasoned GNMA prepayments in recent years. Also, consider loans originated immediately prior to 2001 with those originated in 2001. The former set of borrowers paid an upfront MIP of 2.25% and the latter 1.5%. When they refinance their mortgages, both sets will pay 1.5% on the new loan but the former group will get a larger refund. Other things the same, the former cohorts will be more callable than the latter as long as long as the refunds are material.

BUYOUTS
GNMA servicers are permitted to buy out loans from the trust at par based on certain delinquency triggers; specifically, a servicer can buy out any loan that hits 90-day delinquency or is delinquent four months in a row. While the economics of buy-out is complex, it is almost always profitable to buy out loans from premium priced pools.

Figure 4.

Evolution of the FHA Mortgage Insurance

Upfront MIP 3.8% 3.0% Annual MIP 7 yrs if originally LTV < 90% 12 yrs if 90% <=LTV=< 95% 30 yrs if LTV > 95%

Premium Rules Date of Change Pre Oct-92 Oct 92

Apr-94 Sep-96 January 2001

2.25% 1.75% for first time home buyers 1.5% for all borrowers

Canceled if current LTV drops below 78% based on amortization

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While the buy-out option has been available for a long time, the buy-out intensity has increased in recent years as a secondary market in FHA-VA reperformers bought out loans than have since become current or reperforming. A separate analysis indicates that buy-outs could account for as much as 5% CPR of seasoned premium prepayments.

PREPAYMENT EXPERIENCE
Turnover (Discount Prepayments)
In the late 1980s, fully seasoned GNMA discounts prepaid more than 2% CPR slower than Conventionals (Figure 5), while in the 1990s, GNMAs prepaid close to or faster than Conventional collateral. This reversal was due to two factors the stronger housing market in the 1990s and the introduction of annual MIP in 1992. The strong housing market has boosted discount prepayments on all collateral, but particularly for the credit constrained GNMA borrowers (as indicated by their high LTVs), where the boost to equity encourages trading-up and cash-out refinancing. The impact of annual MIP is subtler; a borrower paying 50 of annual MIP has an effective WAC 50 bp higher than the reported WAC, which is used to construct the curves in Figure 5. The higher effective WAC is easily worth 1%-2% CPR depending on the relative coupon of the collateral.

Refinance (Premium Prepayments)

GNMA collateral has become more callable relative to Conventionals since the 1993 prepayment experience (Figure 6). In addition to the reasons common to the convergence in discount prepayments (discussed above), the increase in buy-out

Figure 5.

Relative Seasoning Profile

a. 19881989 (-75 to -25bp)

% CPR
10 8 6 4 2 0 0 10 20 30 40 FN GN

b. 1/9612/97 (-75 to -25 bp)

% CPR
10 8 6 4 FN GN

c. 1/9912/00 (-75 to -25 bp)

% CPR
12 10 8 6 4 FN GN

2 0 0 10 20 30 40 50

2 0 0 10 20 30 40 50

WALA (mos)

WALA (mos)

WALA (mos)

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Figure 6.

Relative Refinancing Profile

a. 1/9212/93 (1224 WALA)

b. 1/984/99 (1224 WALA)

c. 1/012/02 (12-24 WALA)

% CPR
60 FN 50 40 30 20 10 0 -100 -50 0 50 100 150 200 GN

% CPR
60 FN 50 40 30 20 10 0 -100 -50 0 50 100 150 200 GN

% CPR
60 50 40 30 20 10 0 -100 -50 0 50 100 150 200 FN GN

Rel Cpn (bp)

Rel Cpn (bp)

Rel Cpn (bp)

intensity and the change in upfront MIP in January 2001 gave a further boost to GNMA prepayments during the 2001 refinance episode. Notice, however, that the typical GNMA collateral continues to prepay slower than the corresponding Conventional cohort (Figure 7). This is despite the fact that aside from MIP, the cost of refinancing is lower for a GNMA borrower due to streamlined refinance programs extensively used by the FHA and VA since the late 1980s. The reason is partly the lower loan balance of a typical GNMA cohort and partly the higher effective transaction cost faced by a GNMA borrower because of MIP.

PREPAYMENT MODEL
The new GNMA prepayment model has the same functional form and variables as the Conventional model but differs in terms of the precise impact of these variables as discussed below.

Turnover
The GNMA-Conventional seasoning differences are benchmarked to the 1996-1997 period (Figure 5, middle panel), a period of moderate home price appreciation and one where the MIP regime had been stable for a few years. Brand new GNMA collateral seasons slower than Conventional reflecting the more credit constrained, less mobile borrowers who constitute these pools but the differences erode with seasoning as the build-up in equity encourages trade-up and cash-out refinancing. Figure 8 shows the projected seasoning profile for a typical new pool in a moderate economic environment. While the GNMA collateral seasons slower, turnover levels almost converge after three years.

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Figure 7.

Isolating the Impact of Loan Balance on Prepayment Differentials

1224 WALA Prepayments, 1/984/99

% CPR
60

50

GN FN FN Pools with GN Loan Balances

40

30

20

10

-10 -100

-50

50

100

150

Rel Cpn (bp)

Figure 8.

Model Seasoning Profile*

CPR (%)
12 Conv. 10 GNMA

0 0 5 10 15 20 25 30 35 40 45 50

WALA (months) * Model projections for par-coupon collateral.

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Refinancing
The relative callability of GNMA and Conventional collateral is benchmarked to the 1998-1999 refinance episode for the reasons mentioned above. The main differences between Conventional and GNMA collateral are 1. GNMA collateral is less callablefor unseasoned pools 100 bp in-the-money, GNMA collateral is projected to prepay about 9% CPR slower over one year relative to Conventionals. (Figure 9). The smaller GNMA loan balance accounts for about 4% CPR of this difference and the rest is due to the higher effective refinancing cost for a GNMA borrower as discussed above. For otherwise comparable collateral (WAC, loan size, burnout) pre-2001 originations are more callable than later vintages because of changes in the upfront MIP rules in 2001 as discussed in section 2. The effect is worth about 4% CPR for 100 bp in-the-money collateral. Smaller SATO effectin both the GNMA and Conventional model, high SATO pools are less callable than lower SATO pools, because of the impact of poorer credit. However, this effect is larger for Conventional collateral since, as discussed in section 1, credit quality deteriorates more sharply in high SATO Conventional pools than in high SATO GNMA pools.

2.

3.

Figure 9.

Model Refinance Profile

1-Year Prepayment Rate (% CPR)

80 Conv. GNMA 60

40

20

0 -100 -50 0 50 100 150 200

Relative Coupon (bp)

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VALUATION
Figure 10 summarizes the relative valuation of 30-year TBA collateral. A few items of note. First, GNMA durations are about 0.2 to 0.3 years longer than Conventionals. For par-coupon collateral (6.5s), the longer duration is partly due to the slower seasoning of GNMA collateral (about 0.05 years), but mainly due to the lower callability of GNMA collateral. In discounts (6s), GNMA collateral has higher OAS despite slower turnover rates, since the lower callability reduces the option cost. Note also the higher OAS on GNMA 7.5s despite the 12/32 pay-up. This is mainly because the high WAC (8.13% for Conventionals) 2000 origination is the delivery vintage assumed in that valuation.

Figure 10. Valuation Comparison

a. Conventional versus GNMA: TBA Valuations* GNMA ZV OAS 54 6 72 7 86 5 91 2 92 0 Conventional ZV OAS 56 2 73 4 86 2 84 -6 77 -21

Coupon Vintage Price 6.0 2002 98-28 6.5 2002 101-10 7.0 2001 103-12 7.5 2000 104-30 8.0 2000 106-06

OAD 5.2 4.2 2.7 1.7 1.0

Price 98-26 101-06 103-05 104-18 106-00

OAD 5.0 4.0 2.5 1.4 0.4

b. Conventional versus GNMA : TBA 1-Year Prepayment Projections* GNMA 0 4 10 25 38 41 Conventional -50 0 50 22 5 4 37 14 7 47 35 18 61 45 35 63 52 39

Coupon -100 6.0 30 6.5 45 7.0* 55 7.5 62 8.0 64

-50 10 29 42 49 58

50 3 4 12 26 34

100 2 4 9 16 25

-100 44 53 60 68 68

100 4 5 13 22 31

* As of 5/27/02 at a 6.69% mortgage rate.

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