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Rate Rally Fuels Rising Prepay Speeds

Prepayment rates for 30-year mortgages in Fannie Mae and Freddie Mac mortgage-backed securities jumped in February following a 70-basis-point rally in mortgage rates the month before.

The aggregate speed on 30-year Fannie Mae was a constant prepayment rate of 16.3 CPR, up 70% from 9.6 CPR in January, compared with 15.4 CPR for comparable Freddie Macs, up from 9.0 CPR in January, according to the Bear Stearns Prepayment Commentary.

"In our opinion, the prepayment speeds in this report reflect the full impact of the 70 bp rally in rates," said Bear Stearns senior managing directors V.S. Srinivasan and Dale Westhoff. "Given the low level of mortgage origination activity prior to the rally, the lag between changes in rates and the ensuing prepayment response has likely decreased."

The biggest prepayment spikes occurred in the 5.5% and 6.0% coupons in February, which recorded speed increases of more than 80%, the Bear Stearns analysts said in their latest report.

They went on to attribute the surge in speeds to "a classic 'rate lock' response" to the January rally in mortgage rates.

"The combination of the weak housing market, tighter GSE underwriting guidelines, and increased friction cost due to the new/increased delivery fees is likely to continue flattening the refinancing curve," the analysts said.

"It is important to note that the prepayment speeds in the [February] report do not reflect the full impact of the GSE changes. Moreover, the recent volatility in the mortgage basis is likely to further dampen the prepayment response."

Regarding the 15-year sector, the analysts noted that premium coupons were paying faster than their 30-year counterparts despite the fact that the average loan size is "significantly" lower.

"As the housing market continues to deteriorate and the recent GSE changes are implemented, significant portions of the 6.0% and 5.5% coupons (like the 6.5s of 2007) are likely to have a more muted response to a rally in rates than what we have seen in the past," Mr. Srinivasan and Mr. Westhoff said.

In other prepayment-related developments, Randall Kroszner, a member of the Federal Reserve Board, told the legislative conference of the National Association of Hispanic Real Estate Professionals in late March that prepayment penalties "can take a toll" on consumers with risky loans.

In a speech on protecting homeowners from abusive lending practices, the Fed governor noted that the agency had proposed a ban on prepayment penalties "in circumstances of a high degree of risk to the consumer, and we are also addressing transparency concerns."

The proposed rule would ban prepayment penalties "where the borrower's debt-to-income ratio exceeds 50%, and a penalty would have to expire before a loan's payment could increase," Mr. Kroszner told the NAHREP conference. "The rule would also ban prepayment penalties where they are more likely to be part of a 'loan flipping' scheme - specifically, where a lender or its affiliate refinances the lender's own loan."

The Fed governor added, however, that banning all prepayment penalties "could cause all borrowers, including those who do not prepay, to bear the full cost of investors' prepayment risk, which could raise questions of fairness, and it could reduce consumer choice."

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