Commentary - Payment Option ARMs

There has been much discussion concerning payment option ARMs. Outside of discussing the payment structure, in which the individual have the option of minimum payment, interest only payment or fully amortizing payment on 15 and 30 year terms, we would like to discuss how our MIAC modeling tools can spot both the risks and rewards of owning this product. MIAC has developed system functionality in which the analyst can pick from such functions as prepayment penalty term, penalty collection rate, prepayment pricing model, payment cap, Negative Amortization cap threshold, amortization period, and the four payment options to correctly analyze the net present value cash flow streams of Payment Option ARMs. 

MIAC has performed additional analysis on the impact of higher baseline prepayment speeds on the value of Payment Option ARM servicing rights. A number of factors should be considered when valuing this product. Such factors that have dramatic impacts on MSR values include prepayment penalty periods; Negative Amortization recast threshold, initial teaser rate, average ARM margin rate, and the trend in the moving average MTA rate. In addition, the impact of home price appreciation can contribute to the prepayment and default performance, further impacting the MSR values.

MIAC modeling tools support a variety of vendor based prepayment models and allows customization of prepayment projections. Many of our sample MTA portfolios have prepayment projections spiking at prepayment expiration dates and relatively fast overall speeds. Loans with prepayment penalties reported slower prepayments and had relative value based on the addition prepayment penalty income streams. In fact, most of the payment option ARM composition has some form of prepayment penalty protection in terms of 1 to 3 years. We have seen a handful of product with 5-year penalty protection.

There has been discussion on the merits of owning payment option ARMs in a market with slowing or declining home price appreciation. Bearing a significant housing meltdown: we project housing slowing in the ‘high appreciation regions’ to return closer to their long term growth averages rather than a significant decline. MIAC models project an average life on payment option ARM servicing shorter than it’s recast point. Additionally, the relative fast prepayment speeds will reduce the amount of negative amortization. One sample of our cash flow analysis incorporated a 25% runoff rate average and showed that the prepayment amortization more than compensates for negative amortization levels. With average ltv’s in the 70% range, we project that the higher quality MTA option pools will perform closer to prime ARM product than Alt A.

These MIAC Indexes represents the MSR price behavior of the entire 30-Year Conventional Agency MSR and 30-Year Jumbo MSR market and particular components within the marketplace have increased or declined to a greater or lesser extent. These Indexes DO NOT represent multiples indicative of the value of new production, current coupon servicing rights.
MSR Product Type Price Indexes:

MSR Product Type Price Indexes:

Price Multiples by GSA Product Type Indexes

MSR Price Index Percentage Changes:

Period to Period Percentage Changes

 

Key Interest rates ____________________________________________________________________________

 

Recent Key Market Rates

The 1 Month Libor rate increased by 9 bps through the months of May to finish at 5.11%. Interest rates went up during the same period.The 5-Yr CMS increased by 15 bps and the 10-Yr CMS is up by 11 bps. The yields on the 2Yr increased by 18 bps whereas the 5Yr increased by 12 bps. FNMA and GNMA 30-Yr Current Coupon Yields increased by 21 and 19 bps respectively.

Swap curve Steepened through the month of may. Both the 5 Year Swap- 1 month Libor spreads widened by nearly 7 bps while the 10 Year Swap- 1 month Libor spread increased by 3 bps. Treasury spreads between the 5 Year and 2 Year Note decreased by nearly 5 bps. The FNMA Mortgage-Swap spread and the GNMA Mortgage-Swap spread reversed the trend and widened. The FNMA Mortgage- 10 yr Swap spread widened by nearly 10 bps while the GNMA Mortgage-Swap spread increased by 3 bps. The 2 yr swap rate backed up 18 bps through the month of May and the 10 yr swap rate backed up by 11bps. Short term Swap rates are rising faster than the short term swap rates creating flattening between 2 yr and 10 yr swap rates.

MSR OASs Retrace
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MIAC Analytics makes available Daily GSA OASs through the Daily GSA Pricing Service. Each day, MIAC Analytics will use the previous day’s current volatility of 1-Year into 10-Year swaption volatility as a proxy for mortgage volatility.

The graph below illustrates the OASs computed in MIAC Analytics from the actual GSA prices for nine of the largest GSAs: Conventional 15-Year 5.0% Issue Year 2002, Conventional 15-Year 5.0% Issue Year 2003, Conventional 15-Year 5.5% Issue Year 2002, Conventional 30-Year 5.0% Issue Year 2005, Conventional 30-Year 5.0% Issue Year 2003, Conventional 15-Year 4.5% Issue Year 2005, Conventional 30-Year 5.5% Issue Year 2003, Conventional 30-year 6.0% Issue Year 2002, Conventional 30-year 6.0% Issue Year 2003, GNMA 30-Year 5.5% Issue Year 2003, and GNMA 30-Year 6.0% Issue Year 2002. The graph displays the monthly OASs from 6/1/2005 to 1/31/2006.

GSA OASs followed a Flattening trend through the month of December, but since then have appeared to stay within a certain range. In January, the OASs for these benchmark assets tightened across the majority of asset classes.

Servicing.com has provided daily IO/PO pricing on a portfolio of Trust IOs for several years. As a result, we can provide a comparison of historical Trust IO OASs with the same interest rate model, volatility inputs and OAS cash flow model as the historical GSA OASs. One can see from the table above that Trust IO OASs don’t appear to be well correlated to OAS behavior of the GSAs. This behavior does not support the use of Trust IO OASs as benchmark OASs for the MSR marketplace.

In the table above, the OAS durations or measurements of the anticipated MSR price sensitivity
were computed with a constant OAS.

MSR convexities have continued moving further into their typical negative territory for most Generic Servicing Assets, as rates persistently climb. When convexity is positive, MSR prices will increase more for an upward rate shift, than they will decrease for a downward rate shift. When convexity is negative, MSR prices will decrease more for a downward rate shift than they will increase for an upward rate shift.

OAS Convexity

 

BMA Prepay Speeds - Backing Down
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The following tables reflect BMA historical dealer median prepayment forecasts.

BMA Speeds further slowed down in the month of May with the increase in mortgage rates more than offsetting seasonality trends. The 2004 pools increased across the board with the exception of 5.5 pass-through GNMA 30 yr pools.The 30 yr mortgage rate was 6.35% on the 3rd of April and currently the 30 yr mortgage is 22 bps higher at 6.57%,resulting in speeds slowing down.

On 8/15/2005 the Bond Market Association released a revised listing of mortgage assets and their prepayment speeds to reflect the current mortgage market at the time. These new asset classes do not have historical speeds prior to that date.

 

MedianPSAForecast
Red Indicates the highest forecasts on record and yellow the second highest.

Period to Period Absolute Changes in BMA PSAs:

Period to Period Change in Median PSA Dealer Forecast

More Detailed BMA prepayment information can be obtained at www.servicing.com by viewing the Daily MIMs(Mortgage Industry Medians) data product.

Transaction Summary