Prepayment Speeds Start to Creep Up Again

The speeds of Fannie Mae and Freddie Mac mortgage-backed securities recorded only modest gains in August despite mortgage rates that were about 25 basis points lower than in the previous month.

Bear Stearns analyst Dale Westhoff said the speed gains were generally less than 10%, with the bigger percentage increases concentrated in the 5.0%-6.0% coupons.

The speeds of 2003 vintage Fannie Mae 5.0s increased by a constant prepayment rate of 0.9 CPR, while the prepayment rates of 5.5s rose by 1.3 CPR and those of 6.0s climbed 2.3 CPR, Bear Stearns reported.

"Above the 6.0% coupon prepayment increases were even more muted, with most increases less than 5%," Mr. Westhoff said.

He said the speeds for the August reporting period were slightly below the Bear Stearns projections, and that "most of the incremental refinancing produced by the 50 basis point drop in 30-year mortgage rates in July and August to 5.80% is expected to flow through to the September numbers."

Mr. Westhoff cited recent lows in the 10-year Treasury note yield, which he said "narrowly missed reaching our first key rate threshold" of 4.0%.

A 10-year Treasury yield below 4.0% would correspond to a 5.60% mortgage rate, he said, and would expose the 5.5% coupon (35% of the mortgage market) to refinancing pressure.

"Under this scenario, we would expect the Refinancing Index to approach 3000 and the origination pipeline to begin to fill," Mr. Westhoff said.

The change in Freddie Mac speeds was similar to the slowdown recorded in Fannie Mae MBS, but Freddie Macs are still running a little slower than Fannie Maes across the board, according to Bear Stearns.

"We think this difference could be linked to [Freddie Mac's] lower concentration of loans from California, where the hybrid refinancing effect is much more pronounced than in the rest of the country," Mr. Westhoff said.

Regarding hybrid adjustable-rate mortgages, three Bear Stearns analysts argued in the September issue of Short-Term Prepayment Estimates that they have become popular in California and "are now poised to sweep the rest of the country."

Mr. Westhoff, joined by Bruce Kramer and V. S. Srinivasan, reported that more than 60% of outstanding hybrid ARMs, including interest-only hybrids, were originated in California.

"Against this backdrop California provides us with an excellent laboratory in which to study the impact that this transformation in origination patterns is likely to have on the broader mortgage market," the analysts said. They argued that hybrids, and especially IO hybrids, are likely to have a "profound impact" on the prepayment rates of fixed-rate mortgages, causing them to remain at "elevated" levels.

Over the past 12 months, the market share of ARMs has run at about twice the level that would have been expected based on historical averages, the analysts reported. "This is a clear indication of a structural change in the market and we think Hybrid IOs are responsible," they said.

Comparing historical prepayment rates for California Fannie Mae 5.5s issued in 2002 with those from the rest of the country, the trio of analysts found that speeds were nearly identical through the second quarter of 2003, at which point the California group began paying "substantially faster."

This development occurred at the same time as a "dramatic increase" in California hybrid IO production, they observed, attributing the accelerated prepays to a shift of subprime hybrid borrowers into hybrid IOs.

The analysts predicted that hybrid IOs "will continue to gain in popularity" outside California, especially among lower-income borrowers, and that this will result in a similar prepayment trend in the fixed-rate sector.

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