June Data Shows Accelerating Prepayment Speeds after Lull in May

Prepayment rates for Fannie Mae and Freddie Mac mortgage-backed securities surged in June for recently originated 30-year 5.5% coupons, following a May report that had been termed "the calm before the storm."

Speeds for Fannie Mae '03 vintage 5.5s jumped from a constant prepayment rate of 7.2 CPR to 20.8 CPR in June, while speeds for the '02 vintage soared from 18.6 CPR to 42.4 CPR, a record increase, according to the Bear Stearns Prepayment Commentary.

"This was clearly the 'sweet spot' of the refinancing pipeline, as these borrowers were the easiest and most lucrative to refinance," said analysts Dale Westhoff and Bruce Kramer.

The analysts said the "most notable aspect" of the June report was the divergence in response between lower coupons (6.0% and lower) and higher coupons (6.5% and higher).

"The lower coupons, especially the 5.5s, saw a spectacular jump in speeds based on a first-time opportunity to efinance," they said. ". Since today's report corresponds to a mortgage rate of approximately 5.5% and a (Mortgage Bankers Association of America) Refinancing Index of between 7500 and 8000, we expect to see additional increases develop in next month's report in response to a record low in mortgage rates of 5.25% and a 10000 peak in the Refinancing Index."

In the previous prepayment report, the speeds for most cohorts of Fannie Mae 30-year MBS slowed somewhat in a prelude to the surge in June.

"In percentage terms, no single cohort of significant size slowed by more than 6%," said Messrs. Westhoff and Kramer. "Given the degree of volatility in speeds, and given our expectations for the next record leg of this refinancing wave, (the May) report should probably be thought of as 'the calm before the storm.'"

The analysts noted that the 5.0%, 5.5% and 6.0% coupons of the 2003 vintage were exceptions to the rule in May, as speeds rose anywhere from 0.1 CPR (for 5.0s) to 3.6 CPR (for 6.0s).

Refi exposure had risen from less than 70% in May to 95% in the first week of June, representing $2.73 trillion of the $2.86 trillion agency fixed-rate market, the analysts said.

"More importantly, the average borrower now has a record refinancing incentive of 142 basis points into a 30-year mortgage," the Bear Stearns analysts said. They predicted record absolute speeds in "virtually all coupons" this summer.

In their commentary on the May report, the analysts said traders had been puzzled, in view of record originations, by the "anemic" level of mortgage loan sales by originators.

"One contributing factor might be that more of these loans are being held in portfolio in raw form for their yield and to skirt the mark-to-market risk of MBS," they said. "In addition, large originators may be hedging their pipelines more with options rather than by selling forward in the roll market."

In other prepayment-related news, Bear Stearns recently concluded that FICO scores are the most important of the new MBS disclosures being released by Freddie Mac and Fannie Mae, and that loan-to-value ratios are "a close second."

In a research report titled "A Roadmap to New Pool Disclosures from FNMA and FHLMC," Bear Stearns mortgage analysts Messrs. Westhoff and Kramer and V.S. Srinivasan declared that FICO scores and LTVs "are important not only because they have a profound influence on prepayment behavior, but also because they affect a relatively broad segment of the MBS universe."

The analysts said loans with FICO scores below 700 and LTVs over 80% "exhibit a reduced sensitivity to refinancing opportunities." They reported that about 13% of recent originations fall into one or both of those categories, and said they would expect the percentage to rise to about 19% in an environment dominated by high rates and purchase loans.

Regarding FICO scores, the Bear Stearns analysts said they reveal a good deal about a borrower's credit history.

"Since credit risk drives the underwriting decision process and loan pricing, it plays a crucial role in defining the ability of a borrower to prepay a mortgage," they said. "... The evolution of risk-based pricing in the mortgage industry with FICO at the core of most automated underwriting platforms today ensures its importance as a predictor of both future credit and prepayment performance."

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