Monoline Insurers Will Benefit Most From Paulson's Subprime Plan

Let's take a closer look at Bush and Paulson's sub-prime freeze plan. I've commented that I think it's a good idea, at least in concept, and we really didn't get much as far as new information last Thursday. I now understand that the mass mod will apply to borrowers with a 660 FICO or lower, and the average "teaser" rate they are currently paying is 7-8%. As Tanta at Calculated Risk, puts it, that kind of rate isn't what most people are probably thinking when they hear "teaser." Count me as one of those people who assumed we were talking about "teaser" rates below current market fixed rates. I think the 7-8% figure is very important here. According to Freddie Mac (FRE), the current 30-year fixed rate mortgage rate is about 6%. Anyway, that makes it realistic that some percentage of borrowers will be able to use FHA assistance and/or a municipal housing agency to eventually refi into a fixed rate mortgage. Erin Drankoski, of the New America Foundation estimates that 10-12% of subprime resets would qualify. If only 2-3% could wind up in a fixed rate mortgage, that would make a real difference.

For undoubtedly the best commentary available anywhere, check Calculated Risk.

Anyway, the question of how this all will impact mortgage pools is not currently known. There will likely either be lawsuits or something passed by Congress to prevent lawsuits. So until we get some more details, I'm not sure we can say what exactly will happen to mortgage pools.

However, here are some things I know, some things I think are true, and some things I have questions about. Feel free to comment.

Fannie/Freddie Pools
The interest rate on a Fannie (FNM) or Freddie ARM pool is based on the rate of the underlying loans less a servicing spread. So let's say that your pool starts out with a coupon of 6% and is set to adjust in 3 years. Let's say that the servicing spread is 50bps. That doesn't mean that all the loans have a rate of 6.50%. Some might be 6%, some might be 7%. If it happens to be that the 7% borrowers refinance but the 6% borrowers don't, then the coupon on my pool goes down. My point here is that the GSE didn't promise me 6%, they promised me the full amount the borrowers are supposed to pay. Note this isn't how a fixed rate pool works, where they have indeed promised me a certain coupon.

My reading of the Offering Circular on GSE pools indicates that when a loan becomes seriously delinquent, the GSE buys the loan out of the pool. At that point, the GSE and the service will determine what the best course of action is: mod or foreclose. But as far as the MBS investor is concerned, it's of no moment. The GSE buys the defaulted loan out of the pool at par either way.

I'd suspect what this means is that any loan in a GSE pool which would qualify for the freeze would wind up getting bought out by the GSE. Based on the 660 FICO limit, there aren't going to be a ton of loans in Fannie/Freddie pools which are frozen.

Whole Loan Pools
Non-agency MBS are more complicated. And I freely admit that I'm not an expert in all the different types of whole loan RMBS out there. I have (fortunately) always stuck with GSE pools. Anyway, here is how I understand it, and anyone who knows better should drop us all a comment.

Whole loan interest rates for ARMs are usually set based on some index. Typically LIBOR + a spread. When the deal is initially put together, the investment bankers will run models as to what kinds of LIBOR spreads the deal can afford based on various estimates of prepayments and defaults.

Whole Loan RMBS are subject to an available funds cap. This is a fancy way of say that the trust will pay out what it's got, but if it ain't got it, it ain't paying it out. This is in contrast to a GSE pool, where interest and principal are guaranteed regardless. If the pool is running out of cash, then all P&I will start flowing to the senior tranches, and the junior tranches won't get anything until the senior is completely retired. How "running out of cash" is defined depends on how the deal was originally structured. Usually there is some kind of trigger calculation.

Obviously if the interest on the pools is frozen at the teaser rate, but LIBOR has risen, then the interest flowing to the pools will be less than what was assumed when the deal was modeled. Odds are good that this will trip the trigger, and all cash flow will go to retiring the senior. What's
unknown is whether a) the modified interest will still be enough to pay the senior in full, and b) whether the senior would be better off just foreclosing and taking what they can get now, as opposed to putting off receipt of principal in favor of getting more interest. I'll merely point out that the senior tranches usually had a very tight spread to LIBOR, less than 20bps in some cases, whereas the deal as a whole, probably, has an average interest rate of 400bps over LIBOR or more. So the senior can lose a lot of interest in the pool before there isn't enough to pay the promised amount.

So my view is that the deal benefits senior tranche holders, and REALLY benefits monoline insurers, who mostly care about the senior holders. If the odds of senior holders remaining whole for a longer period of time goes up, that's certainly good for AMBAC (ABK), MBIA (MBI), etc.