Investors Spooked by March Rise in Prepays

A sharp acceleration in the speeds of 30-year Fannie Mae and Freddie Mac mortgage-backed securities in March represented "a warning shot to mortgage investors," according to Bear Stearns & Co.

Fannie Mae speeds rose from a constant prepayment rate of 18 CPR overall to 24 CPR in March in response to a rally in mortgage rates from 5.77% in February to 5.64%, as well as other factors such as a greater number of business days and a 14% increase in seasonal factors affecting turnover, said Bear Stearns analyst Dale Westhoff.

Mr. Westhoff termed the report a warning shot to investors.

"While relative coupon speeds are still well below levels observed in a typical refinance wave, the idea that somehow U.S. borrowers have become indifferent to new refinancing opportunities (a recent popular story) has been put to bed," he declared. "Borrowers viewed the rally and then sharp sell-off in mortgage rates in February as a last and best opportunity to lock in historically low rates. Notably, even seasoned 6.5% and 7.0% coupon borrowers responded aggressively to this new opportunity."

The Bear Stearns analyst said "the most striking feature" of the report was "the uniformly strong prepayment response across coupons and vintages, particularly a reawakening of seasoned premium cohorts after several months of muted prepayments."

Mr. Westhoff cited in particular the speeds of 6%, 6.5% and 7% coupons, which he said rose 7-8 CPR to reach their highest levels since November of 2004.

Turning to prepayment differentials between agencies, the analyst reported that the speeds of 30-year Freddie Mac collateral increased a little more than those of comparable Fannie Maes, but "continued to prepay marginally slower across most coupons and vintages." Ginnie Mae speeds also recorded "sharp increases" in March and continued to exceed those of conventionals, especially in newer vintages, he said.

Mr. Westhoff forecast that prepayments would "retreat from current levels rather quickly."

In the March issue of Short-Term Prepayment Estimates, Mr. Westhoff and Bear Stearns analyst V. S. Srinivasan pointed to the declining refinancing exposure of MBS.

The 5.5% coupon, which they said represents nearly 40% of "the mortgage universe," had moved from being marginally refinanceable to being "outside the refinancing window" in March, they said.

"As a result, the refinancing exposure of the MBS universe has declined from over 40% last month to just 25% today," they reported. "If mortgage rates increase an additional 50 basis points that exposure will be cut in half to just 12%."

The analysts said the "range-bound" mortgage rates in the previous seven months had "facilitated two fundamental changes in the mortgage universe."

The first is the concentration of even more of the market into the 5.5% coupon, such that 70% of the market is at or below that coupon level, they reported. The second is the reduction of the weighted average coupon of the MBS universe from 6.18% in the summer of 2004 to 6.08%.

"Therefore, although the mortgage rate today is still much lower than it was in the summer of 2003 and the summer of 2004 (when it reached 6.40% in both periods), it only needs to increase by 25 basis points to match the lowest level of refinancing exposure since 2000," the Bear Stearns analysts said.

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