Even MBS Below 6% Being 'Whipsawed' by Prepay Threat

Rebounding mortgage rates in late March threatened to "whipsaw" 5.5% and 6.0% 30-year agency mortgage-backed securities, according to mortgage analysts at Bear, Stearns & Co.

Writing in Short-Term Prepayment Estimates, analysts Dale Westhoff, Bruce Kramer and V. S. Srinivasan said the nearly 40- basis-point surge in the average 30-year effective mortgage rate in the third week of March caused the share of outstanding mortgages that are refinanceable to fall from 90% to 73%.

"Nevertheless, another massive refinancing event is now in the mortgage pipelines," the Bear Stearns analysts said, pointing to the 30-year 5.5s and 6.0s as especially vulnerable to getting whipsawed by the rate swing.

"The 5.5% coupon has had no prior incentives, while the 6.0% has had only very marginal incentives up until now," they continued. "Most of these borrowers have already refinanced in the past year and are unlikely to face many obstacles to completing another transaction with fresh documentation available."

The analysts opined that problems related to lender capacity "may be less severe" than in the fourth quarter because "most lenders are now fully staffed and the refinancing machine is running on all cylinders. Therefore, we anticipate that lenders will work through their pipelines more quickly this time around."

In other prepayment-related news, analysts at the Merrill Lynch Global Securities Research & Economics Group recently reviewed prepayments on agency MBS backed by hybrid adjustable-rate mortgages. They concluded that hybrid ARMs prepay faster than fixed-rate mortgages when the mortgage pools are out-of-the-money.

Noting the growing popularity of hybrid ARMs, analysts Desmond Macauley and Akiva Dickstein examined hybrid ARM speeds during the fixed-rate portion of the loan.

They found that refinancing incentives change the relationship between hybrid and fixed-rate prepayments, which "tend to converge as they move deeply in-the-money," the analysts said.

Both hybrid ARM and fixed-rate pools have prepaid at constant prepayment rates of 55%-58% CPR, they found, with incentives of 150 basis points (pools with weighted average coupon rates 150 bps above the prevailing rate for comparable loans).

Hybrid ARM and 30-year speeds "seem to converge when they are deeply in-the-money, yet have very different speeds when they are slightly in-the-money or out-of-the-money," they said, suggesting that the variability of ARM speeds may be less than that of fixed-rate mortgages, the Merrill Lynch analysts said.

But the analysts said the relationship is not quite what it seems.

Hybrid ARM pools have higher baseline speeds than fixed-rate pools, so they accelerate less than fixed-rate mortgage pools when deep in-the-money the analysts determined.

"Yet in recent years, ARMs have appeared to prepay much faster because the ARM rate has been more volatile than the 30-year rate," the analysts said. "In other words, the acceleration of ARM prepayments in the recent refinancing cycle has less to do with the callability of the collateral and more to do with the fact that the ARM rate has rallied by 50 bps more than the 30-year rate in the past two years."

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