Sizing Up Prepays May Come to Fore in Agency MBS

NEW YORK-Prepayment risk has been on the back burner with the Federal Reserve dominating the agency mortgage-backed securities market, but with the Fed's gradual departure from the market underway it could emerge as the key driver - and demand for analysis of it could grow.

With the government and government-sponsored enterprises backing the dominant new-issue MBS market these days, one could argue that for private investors (except to the extent they are taxpayers) "really there is no more credit risk but there is still prepayment risk," said John Jay, senior analyst at Aite Group.

In other words, because the government currently is backing the product (in one sense or another, with the Treasury recently having shored up its temporary conservatorship of the agencies) and underwriting is tighter today, investors outside the federal government won't be worried about poor mortgage performance except to the extent it causes securities to prepay, he said.

All this, combined with pricing that is expected to look relatively advantageous upon the Fed's departure, is expected to bring a greater number of private investors back into the market to "fill in" for the Fed to some extent when it leaves and avoid a shock to the market due to its exit.

Mr. Jay said he has become concerned recently that much of Main Street does not understand this dynamic and mistakenly think the Fed's departure from the market will cause a huge and sudden increase in rates. More likely, the main risk for MBS is likely to be loan buyout-driven prepayments that affect high premium coupons.

"Changing buyout incentives with adoption of [accounting standards] FAS 166 and 167 as of Jan. 1, 2010 should drive delinquency-related prepayments higher, leading us to expect higher premiums to prepay substantially faster," Deutsche Bank said in a recent research report.

However, Wall Street researchers and Mr. Jay generally think market conditions and developments as well as available analysis of this risk should make it manageable.

"While buyouts should ramp up quickly, we believe an extreme ... buyout scenario is unlikely," Barclays researchers said. They indicated they think GSEs would likely act to avoid an extreme wave of buyouts in order to avoid disrupting the fragile housing recovery, the MBS market and the value of their own MBS.

In addition, if the current steepness of the yield curve holds it could spur demand and creation of collateralized mortgage obligations, which can be used to further strategies aimed at mitigating prepayment risk, Mr. Jay said. CMOs do this by allowing pass-throughs to be bundled and synthetically carved up and structured in various ways along the range of the yield curve in ways considered to be conducive to cash flow management as well as to a range of investors.

While bank appetite for CMOs is anticipated to be strong, as at least one Wall Street expert has noted, if the market trends toward a rally that lifts yields on the long end of the curve demand from investors there could be somewhat questionable. But Mr. Jay notes that there is more to investor demand than calling a top or bottom to the market. Longer-end CMO investors like insurance companies, which use MBS for asset-liability matching purposes, need to buy the securities to match their liabilities when they run off regardless of whether a top or bottom to the market has been called, Mr. Jay said. "They need to refill that bucket," he said. When asked if the crisis' dulling of the appetite for more complex structured product might affect demand for CMOs, Mr. Jay acknowledged that some structures could be volatile.

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