MBS Prepayment Rates Slow Down Sharply in May

Prepayment rates for Fannie Mae and Freddie Mac mortgage-backed securities plunged among major coupons during the May reporting period.

The constant prepayment rates of Fannie Mae 5.5% coupons fell the most in absolute terms, by as much as 15 CPR, Bear Stearns analyst Dale Westhoff reported in the Bear Stearns Prepayment Commentary.

The analyst said the speeds of "moderately seasoned" 5.5s are likely to continue slowing and may drop as much as another 20 CPR by the fall.

He also said the slowdown points to important differences in the behavior of agency MBS speeds compared with those of last year.

"Clearly, there will be no repeat of last summer's protracted refinancing event that resulted from mortgage pipeline delays," Mr. Westhoff said.

Forecasting convergence in agency prepayments, the analyst said the MBS market's refinancing exposure is "the weakest it has been since the fourth quarter of 2000, with less than 25% of the borrower universe having any incentive to refinance at all."

Mr. Westhoff said Bear Stearns expects record housing turnover to push "relative coupon prepayments" well above the levels of 2000, which he said was the last discount MBS environment.

"Strong recent home price appreciation is the largest contributing factor to that expectation," he said.

Noting that the prepayment slowdown was "muted" among coupons 6.5% and higher, Mr. Westhoff said the "next step in the transition to a 'low beta' prepayment environment will occur when the slowdown extends farther up the coupon stack."

Mr. Westhoff and fellow analysts Bruce Kramer and V.S. Srinivasan delved further into the concept of low-beta prepayments in the June issue of Bear Stearns' Short-Term Prepayment Estimates.

The analysts explained that low-beta prepayments refer to a period in which both premium and discount coupons reach "long-run equilibrium" speeds and prepayment behavior becomes "very insensitive" to interest rates. In addition, purchase originations approach or exceed 80% of loan production.

"We expect to enter our next low-beta period by the fourth quarter of 2004," they said, adding that such periods are "extremely valuable" to statistical modelers because "they drive our assumptions for long-term model projections under static interest rate scenarios."

The analysts identified four low-beta prepayment periods since 1989: January 1989 to December 1990, July 1994 to June 1995, July 1996 to June 1997, and December 1999 to November 2000.

After reviewing important housing variables during those periods, the analysts concluded that recent levels of home price appreciation "play a pivotal role in expected prepayments in the discount coupons."

This makes sense, they said, because "rising equity levels provide borrowers with both the assets necessary to trade up in homes and access to more flexible and competitive financing programs."

The trio of analysts said the key role played by home price appreciation augurs well for the MBS market, because the latest three-year appreciation rate is higher than those of the four above-mentioned low-beta periods.

"Against this backdrop, we expect record discount coupon prepayments to emerge later this year as we enter our next low-beta prepayment environment by the fourth quarter of 2004," they said. "We expect these levels to exceed even the 2000 experience by from 15% to as much as 20%."

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