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Analysts Rethinking Prepay Assumptions

The subprime credit crunch is prompting some in the mortgage-backed securities industry to revise assumptions about housing turnover in order to align their prepayment models with new market conditions, according to Andrew Davidson & Co.

In an article titled "Model Adjustments in Light of the Credit Crunch" in a recent issue of The Pipeline, analysts Dan Szakallas and Sanjeeban Chatterjee noted that the "staggering losses" on subprime portfolios have spurred lenders to impose tighter underwriting guidelines.

"Borrowers who may have been approved for larger loans or lower rates a year ago are seeing that the amount they can borrow, even with good credit, is less than in the past," the AD&Co. analysts said. "Coupling this with very modest home price appreciation over the last year (about 4.5%) has led to a steady decline in existing home sales every month since February."

This runs counter to the trend in a normal year, when resales rise from February to August, they noted.

"This trend was last seen in 2005 when existing home sales topped out in September at around 7.2 million units," the AD&Co. analysts said. "This year, however, we have seen the numbers drop from 6.68 million units in February to 5.75 million as of July, so it seems as though the impact of the tighter underwriting guidelines is being seen."

AD&Co. said the situation is causing some in the MBS industry to revise their housing turnover models to account for the new market conditions. "Models are overpredicting the rate of housing turnover, and it will most likely be a few months before the market corrects itself to return to historical averages," the AD&Co analysts said.

For example, the data indicate that AD&Co.'s prepayment model has been "slightly fast" in forecasting constant prepayment rates for discount coupons over the past three months, the analysts reported.

One question posed by the credit crunch is how current market conditions will affect peak reset speeds for adjustable-rate mortgages, especially subprime. Will the peak speeds reach the same levels as they have historically?

"The answer is that we do not know for certain," the AD&Co. analysts said. "Version 5.2c of the AD&Co Prepayment Model is modeled such that speeds increase around the first through fifth reset periods. The model was developed using data through 2007 and the current model peak speeds correspond to speeds observed in the historical data. We are closely monitoring all 2002 through 2005 vintage loans to see whether any significant changes can be observed in the peak speeds."

The analysts noted that borrowers have little incentive to refinance to lower rates or to cash-out some equity now that rates have risen and home prices have stabilized. Meanwhile, rates will rise at reset, boosting payments to levels "that might be a stretch for some borrowers (at least in the subprime sector)," which could lead to rising defaults.

The analysts said the AD&Co. pool-level prepayment model projects total terminations and does not distinguish between voluntary prepayments and defaults.

"So even though the peak speeds might not reach the levels seen before, they may be offset somewhat by rising defaults," they said. "We are currently studying these phenomena - peak speed levels and the effects of rising defaults, using the most current data available for agency and non-agency prime and subprime loans." (c) 2007 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com http://www.sourcemedia.com/