Flatter Yield Curve Could Vex Prepay Analytics
After a year notable for defying historical precedent on the prepayment front, the market faces growing uncertainty with the prospect of flattening interest rates, according to a Bear Stearns & Co. review-and-outlook analysis.
In the January issue of Short-Term Prepayment Estimates, analysts Dale Westhoff and V. S. Srinivasan noted that the speeds of mortgage-backed securities ran counter to the conventional wisdom in several areas last year.
For example, Ginnie Mae MBS prepaid faster than conventionals and expanded-criteria loans prepaid faster than prime loans, they said.
Pointing to the "bearish flattening interest rate scenario" now facing the market, the analysts said this scenario "brings into question the viability of the current housing market, current home prices and, ultimately, current MBS prepayment assumptions."
In addition, the uncertainty is magnified by the fact that prepayment models must hark back to the 1999 and 2000 experience to try to forecast future prepayments because "it has been four years since a discount dominated, non-refinance MBS market even existed," the Bear Stearns analysts said.
The key rate/refinancing threshold in the coming months is "the 5.60% to 5.40% mortgage rate corridor," they said, reporting that MBS refi exposure jumps from 35% at the former level to 65% at the latter.
According to the analysts, most of the recent changes in prepayment behavior can be linked to three external factors: record home price growth, expanded access to credit, and the growth of products targeting "affordability."
These factors have helped bring about the fastest discount prepayments on record, a "shrinking universe of fixed-rate, fully amortizing mortgages," and challenges to established prepayment conventions, they said.
The Bear Stearns analysts cited what they called a consensus that the 10-year Treasury yield will probably near 5.0% by the fourth quarter of 2005. As a result, extension risk "is once again one of the biggest concerns in the mortgage market," they declared.
Seeing "very little upside potential" for prepayment rates this year, the analysts predicted a gradual move to "slower relative coupon prepayments" even if rates hold steady.
"While this view does not imply a housing correction, it does suggest that there will be a gradual saturation in new demand for both purchase and refinance transactions," they said.
This year is likely to be dominated by purchase transactions, and because purchasers have no tenure, minimal equity, and higher transaction costs than refi borrowers, they have "a much lower probability of prepayment in the near term," according to the analysts. Another factor that may increase extension risk is weakening housing turnover, they said.
"From our perspective, the ability of the housing market to maintain its current pace of home price growth in a rising rate environment is the key determinate to what happens in 2005," the analysts opined. "... Although there are many ancillary factors that influence housing turnover prepayments, none are as powerful as home prices."
In other prepayment-related news, a recent study found that subprime borrowers subjected to prepayment penalties are given higher interest rates on purchase loans and that homeowners in minority neighborhoods are 35% more likely to get a prepayment penalty than their non-minority counterparts.
Lenders maintain that they offer a lower interest rate on loans with a prepayment penalty, but the study by the Center for Responsible Lending, Durham, N.C., found that in 2002 borrowers with a 30-year, fixed-rate, purchase subprime mortgage with a prepayment penalty paid an interest rate 40 basis points higher than for a similar loan without the penalty.
CRL estimates that borrowers who obtained a subprime loan in 2003 will pay up to $881 million in excess interest over the life of their loans.
"Not only do prepayment penalties lock borrowers into the higher-cost subprime market or force them to give up the wealth they have built through homeownership, but they also turn out to offer no benefit to borrowers in the form of lower interest rates, as the subprime industry has claimed," said CRL president Mark Pearce.
"These abusive prepayment penalties operate as a hidden fee that disproportionately affects both rural and minority neighborhoods."
Copyright 2005 SourceMedia, Inc. All Rights Reserved. http://www.sourcemedia.com http://www.mortgageservicingnews.com