Ginnie Mae MBS seen vulnerable to FHA loan losses

NEW YORK - Investors in U.S. mortgage bonds backed by the Federal Housing Administration own one of the safest bets on Wall Street, yet mounting defaults on the underlying collateral are seen posing risks.

Ginnie Mae pools loans backed by the FHA and Veterans Administration and packages them into mortgage-backed securities. Unlike its mortgage market counterparts, Fannie Mae and Freddie Mac, they carry the full faith and credit of the U.S. government.

But homeowners have increasingly been defaulting on their mortgages, leading to uncertainty about the timing of cash flows and raising the risk that Ginnie Mae bonds will be paid back early, a phenomenon known as prepayment risk.

MBS investors do not want to be paid early. An issuer may repurchase loans which are in default and this repurchased loan is paid in full to the investor at par, who then must reinvest the proceeds, possibly in lower yielding securities. The only risk of loss is to the extent an above par price was paid.

Ginnie Mae bonds have become very richly valued on the back of their government guarantee, and some investors are exiting the debt because they don't think the prices can hold.

We have been net sellers of Ginnie Mae MBS due to rich valuations of these securities, said Jeffery Elswick, director of fixed income at Frost Investment Advisors in San Antonio, Texas.

So far in 2009, Ginnie Mae MBS prepayments have been running ahead of Fannie Mae and Freddie Mac due to greater, relative to the other U.S. mortgage agencies, mortgage defaults as well as a shorter timing in loan modifications.

This has resulted in higher prepayment volatility and lower future relative valuations in Ginnie Mae MBS relative to the other conventional agency MBS, Elswick added.

Some 7.8 percent of FHA-backed loans were 90 days late or more delinquent, or in the foreclosure at the end of June, according to the Mortgage Bankers Association, up from 5.4 percent year ago.

These loan losses have taken a toll on the FHA's reserves.

The FHA on Friday proposed a number of rules changes designed to improve credit quality of FHA-guaranteed loans. The changes are expected to help rebuild reserves falling below congressionally mandated levels.

In research published on Friday, Citigroup said the changes should lead to slower Ginnie prepayments, especially for higher-premium coupons.

Over the long run, the rules are likely to further improve Ginnie Mae credit quality, Citi said.

Matt Hastings, portfolio manager of the Schwab Premier Income fund, who is based in San Francisco, California, said prepayment risk is inherent in Ginnie Mae MBS, but they are trying to limit their exposure, although they cannot reduce it entirely.

Hastings, also co-manager of the Schwab GNMA fund, said their strategy is to focus on older, or seasoned, bonds, for example, those backed by loans originated earlier this decade.

Seasoned securities have more voluntary and involuntary prepayment history for investors to analyze, he said.

GINNIE MARKET SHARE GROWS

Ginnie Mae and the FHA, units of the U.S. Department of Housing and Urban Development, have been pivotal players in the hard-hit U.S. housing market. The FHA extends credit to borrowers who in many cases could not afford large down payments or who wanted to refinance, but had little home equity.

Ginnie Mae's market share, while a relatively small component of the roughly $5 trillion agency MBS market, has ballooned.

The Ginnie Mae MBS market surged to $640 billion at the end of 2009's first quarter from $450 billion at the end of 2007. During the same time, Fannie Mae increased to $2.855 trillion from $2.259 trillion, while Freddie Mac grew to $1.819 trillion from $1.727 trillion, according to Arthur Frank, director and head of MBS research at Deutsche Bank Securities in New York.

The demise of the securitization market at the end of 2007 is behind the growth since the only outlet for new securitization became Fannie Mae, Freddie Mac and Ginnie Mae, he said.

Ginnie Mae MBS prices have gained more than Fannie Mae MBS, mostly since investors have demanded higher credit quality and depository investors prefer an asset with a lower risk weighting toward regulatory capital, according to Kevin Cavin, a mortgage strategist at FTN Financial Capital Markets in Chicago.

MBS from Ginnie Mae have a zero percent risk weighting, while Fannie Mae and Freddie Mac have a 20 percent risk weighting.

This has made banks big buyers, Cavin said.

Using the 30-year 5.00 percent MBS coupon -- the most liquid coupon -- as a proxy, Ginnie Mae has seen 24 basis points more spread tightening to Treasuries this year than Fannie Mae, he said.

Ginnie Mae's 30-year 4.50 percent coupon is at it richest level since April versus Fannie Mae's 4.50 percent issue.

Todd Abraham, co-head of government and mortgage-backed securities at Federated Investors in Pittsburgh, Pennsylvania, said he is not overly concerned about Ginnie Mae MBS.

While the prepayment risk for Ginnie Mae defaults/repurchases is not insignificant, it is manageable and preferable to the substantial losses that are occurring in sectors lacking the government guarantee, he said.