LEHMAN BROTHERS

Fixed Income Research

Prepay Characteristics of Relo MBS

November 4, 2003 Vikas Reddy vshilpie@lehman.com Marianna Fassinotti mfassino@lehman.com

RELO MORTGAGES VALUE IN A DISCOUNT ENVIRONMENT

With increased concentration of the MBS universe in the lower coupons, extension risk has become a big concern for mortgage investors. Over the past six months, the average coupon of the mortgage market has drifted lower by nearly 75bp with overall duration of the MBS Index lengthening by more than 2.5 years. The painful market gyrations of July have also played an instrumental role in increasing aversion for extension r isk among mortgage investors, especially from asset/liability players. The most direct strategy of buying extension protection in the mortgage market is either through structure (PACs and VADMs) or through seasoning. While such strategies do provide the desired protection, the market demands a pay-up for such securities presenting investors with the classic yield/convexity tradeoff. An often overlooked source of cheap convexity in the MBS market is relocation mortgages or relos. While relos remain a relatively small sector of the overall mortgage market, their unique prepayment characteristics warrant attention. In addition to faster base case turnover rates, the likelihood of repeat relocations results in less extension risk and lower prepayment volatility, i.e. better convexity, than regular conventionals. Based on prepayment data from the discount environment of late 99 and 00, we expect relocation mortgages to prepay at about 15%CPR. While data from the turnover experience is less forthcoming, current coupon relos (for pools between 12-24 months of seasoning) prepay around 3% CPR faster than regular conventional mortgages. As these become discounts on the order of 100bp, the differential from conventionals increases to 6% CPR (100PSA).

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A relo is a loan originated to a transferred employee of a corporation

Back to Basics What are Relos? A relocation mortgage is a loan originated to a transferred employee of a corporation to finance the purchase of a primary residence at a new job location. Both Freddie Mac and Fannie Mae have active programs for securitizing relos, with specific eligibility requirements ensuring that qualifying mortgages are subsidized loans made for relocation purposes. Eligibility in the Agency programs is limited to employees transferred through a corporate relocation program. Loans made to a newly hired employee to induce the employee to accept an offer of employment with the corporation are not eligible. In addition, loans resulting from an entire office or plant relocation or from an employees one-time job change with his or her current employer are also not eligible. To qualify as a relocation mortgage, the loan must be sponsored by a corporate relocation program, and must involve a significant employer contribution to mortgage financing. A significant employer contribution to mortgage financing means any financial contribution or combination of financial contributions that singularly or together constitute at least 3 percent of the original principal amount of the new mortgage. Employer contributions to mortgage financing must consist of one or more of the following: A buydown or subsidy of the mortgage interest rate. Payment of the borrowers closing costs (including loan discount points and origination fees) on the new primary residence and/or the previous residence. The funding of a below-market rate or no interest bridge loan. Payment of the difference between the property tax and/or mortgage interest rate obligation on the employees previous primary residence and the employees new primary residence.

Qualifications for relo mortgages include a significant employer contribution to financing

Lenders view relocated employees as low risk borrowers

Understanding Borrower Characteristics Over the past several years, surveys conducted by professional relocation organizations have helped to better differentiate relo borrower characteristics from those of non-relo borrowers. Transferred employees tend to be higher-income, middle- and upper-level managers of large corporations, assigned to new locations for short periods of time either to broaden their management experience or to work on short-term projects. Based on demographics identified in a 2001 study by the Employee Relocation Council 1 , the average transferred employee is 38 years of age, married, and earning an income of approximately $68,500. Thus, lenders typically view relocated employees as low risk mortgage borrowers. Since the majority of relocated employees have been with their company for several years and are relocating due to a recent job promotion, they are considered valued workers who are unlikely to be hastily terminated. Furthermore, the corporations decision to relocate the employee suggests significant regard for their skills, given the average cost to relocate an employee homeowner in 2000 was $57,279. The short-term nature of the typical relocation assignment has implications for future transfer potential and, consequently, the prepayment characteristics of securities backed by relo loans. Compared to non-relocation securities, prepayments on relocation securities are more heavily influenced by factors other than interest rate changes, such as the likelihood of repeat relocations, prevailing economic conditions, and the type of subsidy provided by the employer. For example, surveys2 indicate that over 65% of transferees are likely to relocate within the next 5 years, with 9% likely to relocate within the next year. In addition, over 53% of relocated employees have transferred more than once during the past 5 years.
1

Prepays on relocation securities are heavily influenced by repeat relocations, prevailing economic conditions, and the type of employer subsidy

Source: Employee Relocation Councils 2001 Relocation Assistance Transferred Employees Report & Transfer Volume and Cost Survey Source: Wells Fargo Mortgage Conforming Relo Borrower Analysis Survey, 7/94-3/02.

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Relos have higher base case turnover; current coupons prepay around 3% CPR faster than conventionals.

Prepayment Characteristics of Relos Fast in a Discount Environment Our analysis of agency relo prepayments includes all conforming loan pools securitized by Fannie Mae and Freddie Mac since 1996, representing approximately $11.7 billion of original face value. The analysis of the underlying borrower characteristics clearly indicates that the relocation mortgages should exhibit higher base case turnover. Empirical data supports this hypothesis. For pools between 12-24 months of seasoning, current coupon relos prepay around 3% CPR faster than regular conventional mortgages. Fully seasoned prepayments on relos have averaged close to 15% CPR over the past five years. Repeat relocation is the significant factor in explaining the higher base case turnover rate observed on relo mortgages. However, even in the event that the relocated employee has reached his/her final destination within the organization, turnover on relo mortgages may still exceed comparable non-relocation loans. Many relocated employees who hurriedly purchase a home when first transferred will eventually resettle in a better home, location, or school district after learning more about the new region. Figure 1: Relo v. Conventional Prepayments, Apr-1999- Present, 12-24 WALA
30yr Relo % CPR 30 25 20 15 10 5 0 -200 -150 -100 Relative Coupon (bp) -50 0

Because of repeat relocations, relos have muted lock -in resulting in less extension risk and better convexity.

Lower Lockin Further Reduces Extension Risk While the turnover rate on relo mortgages is significantly higher than non-relos, from an investment perspective the more compelling prepayment characteristic is the reduced sensitivity to changes in interest rates. As interest rates increase, the average life of mortgage securities extends due to decreasing voluntary turnover. Lock-in describes the decreasing likelihood that a borrower will voluntarily move or trade-up when their current mortgage rate is significantly below prevailing mortgage rates. Because of repeat relocations, however, relo mortgages show muted effects of lock-in resulting in less extension risk and better convexity. In Figure 1, we compare the seasoning curves of current coupon and discount relos. There is little difference in fully seasoned prepayments on current coupon and discount relos. In contrast, this difference is 5% CPR for regular conventionals, indicating the muted lockin in relos. Taking a closer look, we compare data on the two most recent discount periods, namely April 1999 through November 2000 and July 1994 through November 1995. Due to the lack of considerable data, we minimize the noise in the numbers by selecting representative coupon/vintages. During the first period, 6% 1998 vintage relos sustained prepays above 10% CPR. This level is about 6-8% CPR faster than conventionals (Figure 2a). During the discount period of the mid 1990s, overall prepayments were more muted. Yet, the difference between relo and conventional prepays remained significant. Relo 1993 6s and 6.5s, the two largest
3

During the mid 90s, relo 1993 6s and 6.5s, the two largest cohorts, prepaid 11%CPR and 9%CPR faster than conventionals

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cohorts representing $1 billion combined, prepaid 11%CPR and 9% CPR faster than conventionals at their peak (Figure 2b).

Figure 2: Historical Relo vs. Conventional Prepayments During the strong housing market of the late 90s, relos prepaid 6-8% CPR faster (a.) 1998 6s, Apr 1999 Nov 2000
% 9.00 8.50 8.00 7.50 6% 4% 2% 0% Apr-99 Jul-99 Oct-99
CPR Diff

% CPR Difference 14% 12% 10% 8%

7.00 6.50 6.00 Jan-00 May-00 Aug-00

30yr Mtg Rt (RHS)

During the weaker housing market of the mid90s, relos still prepaid 4-5% CPR faster

(b.) 1993 6s, Jul 1994- Nov 1995

% CPR Difference 14% 12% 10% 8% 8.0 6% 7.5 4% 2% 1993 6s 0% Jul-94 Oct-94 Jan-95 Apr-95 Aug-95 Nov-95 1993 6.5s Mtg Rate 6.0 7.0 6.5 Rate 10.0 9.5 9.0 8.5

Relo borrowers display similar rate sensitivity at moderate rate incentives to that of non-relo borrowers

Finally, on the callability front, relo borrowers display similar rate sensitivity at moderate rate incentives to that of non-relo borrowers, despite characteristics which suggest the opposite. The rationale is pretty straight forward. A relocation borrowers shorter horizon will naturally result in the need for a greater rate incentive to outweigh the fixed cost of refinancing. Moreover, since the borrowers rate is often the form of a subsidy, the actual gross WAC of the borrower may be significantly lower, reducing the true rate incentive of the borrower. Yet, at very high rate incentives (i.e- +100bp), the better credit of relo borrower as well as their muted burnout results in higher callability versus conventional borrowers.

November 4, 2003

Lehman Brothers | Fixed Income Research

Mortgage Strategies

I, Vikas Reddy, hereby certify (1) that the views expressed in this research report accurately reflect my personal views about any or all of the subject securities or issuers referred to in this report and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report. Any reports referenced herein published after 14 April 2003 have been certified in accordance with Regulation AC. To obtain copies of these reports and their certifications, please contact Larry Pindyck (lpindyck@lehman.com; 212-526-6268) or Valerie Monchi (vmonchi@lehman.com; 1-011-44-207-011-8035).
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