By the Numbers

That ticking sound could be a 40-year FHA loan mod

Brian Landy, CFA | July 16, 2021

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Prepayment speeds in Ginnie Mae MBS could jump if the FHA were to introduce a 40-year loan modification into its approach to loans coming out of Covid-19 forbearance. Ginnie Mae lately announced it would allow securitization of 40-year loans starting in October, suggesting a 40-year mod may be under consideration. If servicers have to offer a 40-year FHA mod before other loss mitigation options, servicers could be forced to buy a sizable set of delinquent loans out of MBS. It is not certain, of course, that FHA will offer a 40-year mod or that it would come early in the loss mitigation waterfall. But the biggest impact would fall on 2016 through 2020 vintage pools with 3.5% and higher coupons. The amount of principal returned to investors could reach 10% to 20% of the outstanding balance in many of these cohorts.

The FHA on June 25 introduced a new loan modification program, known as the Advance Loan Modification (ALM). Servicers are required to evaluate all borrowers that leave Covid-19 forbearance for the ALM and offer an ALM to all borrowers that qualify. This must be done before considering other loss mitigation options like the FHA’s payment deferral program, known as a partial claim. Loans that receive a partial claim do not need to be bought out of their pool, but loans that are modified must be bought out. The ALM adds delinquent interest, taxes, and insurance to the unpaid principal balance of the loan, changes the note rate to the current value of Freddie Mac’s Primary Mortgage Market Survey (PMMS) rate rounded to the nearest one-eighth, and re-amortizes the loan over 30 years. Borrowers qualify if the principal and interest payment is reduced by at least 25%. A detailed discussion of the program is available here.

The FHA may be planning to offer a 40-year loan modification. Many additional borrowers will qualify for a loan modification if this becomes part of the ALM program (Exhibit 1). The top section shows the percent of each Ginnie Mae MBS cohort’s UPB that would qualify for a loan modification with a 2.875% note rate and 40-year term, while the middle section uses the same note rate and a 30-year term. Borrowers are assumed to use the maximum amount of Covid-19 forbearance. The bottom section of the table shows the difference between the two scenarios—the increase in eligibility if the FHA were to introduce a 40-year ALM.

Exhibit 1. A 40-year Advance Loan Modification

Percent of cohort UPB as of 7/1/2021 that would qualify for an Advance Loan Modification assuming maximum use of forbearance and a 2.875% mortgage rate. Ginnie Mae loan-level data was used to estimate the amount of past-due principal, interest, taxes, and insurance. Taxes and insurance accrue at 12 bp each month.
Source: Ginnie Mae, eMBS, Amherst Pierpont Securities

Only borrowers in premium pools or seasoned pools qualify for an ALM with a 30-year term, although the reach of the program would increase if interest rates fell to 2.75% or lower. But it is easier for a borrower to achieve the required payment reduction using a 40-year ALM. Most loans in 3.5% and higher coupon pools would qualify, even pools issued as recently as last year. The biggest change is to 2016 and newer vintage pools with coupons 3.5% and higher, and those cohorts have the greatest UPB at risk of buyout.

For example, loans in 4% coupon pools receiving a 30-year ALM must have been originated before 2015 to qualify. But with a 40-year modification the largest effect on 4% coupon pools is to the 2019 vintage—13.5% of that vintage could be bought out at par.

However, a major obstacle to a 40-year modification is the lack of a market for Ginnie Mae MBS with maturities longer than 30 years. Servicers are required to buy out modified loans from pools at par, and this capital is raised by selling the modified loan into a new Ginnie Mae MBS. Therefore, pricing is critical since the servicer needs to receive at least par. And servicers need the sale to exceed par to cover operating costs. This is typically achieved when selling a 30-year loan modified to the 30-year PMMS rate. But a 40-year loan modified to the 30-year PMMS rate might trade at a discount, a risk made larger since there is not a liquid market for 40-year Ginnie Mae MBS. This would be a disastrous scenario for servicers that would not have the capital to make up the difference.

Servicers could try to avoid creating 40-year modifications if they are forced to implement the program and if pricing for these loans is poor. For example, the FHA has made the ALM extremely simple to process and offer to borrowers. However, servicers could make the modification sound confusing and suggest that a better alternative exists, hoping borrowers would reject the modification.

It is also possible that the FHA will create a 40-year modification but not incorporate it in to the ALM. The potential increase in buyouts would vanish If a 40-year mod came after the partial claim in the post-Covid waterfall and would reduce the number of 40-year modifications performed. This would benefit investors and servicers.

Brian Landy, CFA
brian.landy@santander.us
1 (646) 776-7795

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.

Important Disclaimers

Copyright © 2024 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.