Mortgage Prepayment Speeds Are Starting to Rise Again
Prepayment rates for Fannie Mae mortgage-backed securities rose broadly in February, as coupons below 6.5% recorded greater-than-expected speed increases.
The speed-up prompted the Bear Stearns Prepayment Commentary to caution that the increases may adversely affect MBS pricing for 5.5% and 6.0% coupons, which saw average speeds rise by constant prepayment rates of 7-8 CPR for the former and 10-12 CPR for the latter.
Bear Stearns analysts Dale Westhoff and Bruce Kramer attributed the strong showing to three factors: excess capacity in the mortgage pipeline, a doubling of application volume since early January and "attractive" hybrid mortgage alternatives.
The excess capacity "has compressed the lag between interest rates and reported prepayments to just four weeks," the analysts said.
Citing the shorter lag time and the larger number of business days in March, the analysts predicted that prepayments would rise again in the next report, by about 15%, but added a caveat.
"It is important to note that despite the sharp increases in today's report, the numbers are still well below where they were the first time mortgage rates hit 5.65% in March 2003," they said. "For example, the 6.0% 2002 vintage reached 50 CPR back then vs. just 38 CPR today."
Meanwhile, in the March 2004 issue of Bear Stearns' Short-Term Prepayment Estimates, Mr. Westhoff, Mr. Kramer and V. S. Srinivasan addressed the issue of extension risk.
The analysts said they expect extension risk to rise as the refinance share of originations falls below 30%, which they noted has not occurred since 2000.
"If the market's expectation of rising rates is realized in 2004, we expect to see this transition take place over a relatively short period of time," they said.
(As average 30-year mortgage rates fell below 5.5% in early March in Freddie Mac's Primary Mortgage Market Survey, the refi share of originations totaled over 55% in the Mortgage Bankers Association's Weekly Mortgage Applications Survey.)
Performing a standard extension-risk analysis on the current Fannie Mae MBS universe, the analysts found that "today's ramp is steeper and the terminal speed higher than at any other comparable period in our prepayment database."
The trio then looked at an element they said is normally overlooked in a standard analysis: the purchase vs. refinance loan composition of the MBS universe.
While a standard analysis considers the age of the loan, it does not consider whether it was originated in a purchase or a refi transaction, they observed.
"This is a critical distinction since the vast majority of loans originated in 2002 and 2003 were to refinance an existing loan [we estimate that from June 2002 to June 2003 the refinance share of originations was over 70%]," the analysts wrote.
"By definition," they continued, "a refinance transaction involves an existing homeowner who has tenure in the home and who is in reality further along the seasoning ramp. Moreover, given the strong home price appreciation that has characterized the recent U.S. housing market, the additional tenure of refinance borrowers usually means they have substantial levels of equity in their homes."
Relying on the new MBS disclosures provided by Fannie Mae and Freddie Mac, the analysts were able to distinguish 2003 loan pools with heavy concentrations of purchase loans from those with heavy concentrations of refis.
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