Falling Prepays Highlight Extension Risk

Prepayment rates of 30-year Fannie Mae and Freddie Mac mortgage-backed securities fell significantly in April, and analysts at Bear Stearns & Co. cautioned that this should serve as a reminder of extension risk.

Speeds on 30-year Fannie Mae collateral declined from a constant prepayment rate of 24 CPR to 19 CPR overall, while Freddie Mac speeds declined by similar amounts and remained slower than Fannie speeds, analysts Dale Westhoff and Steven M. Bergantino said in the Bear Stearns Prepayment Commentary.

"Improved seasonal factors affecting turnover gave way to the drag imposed by a sharp backup in rates and a two-day decline in the business calendar," they said.

The Bear Stearns analysts said the drop-off in speeds "should be a reminder of the extension risk currently looming over the fixed-rate mortgage market."

The previous month's prepayment spike "proved that borrowers will still respond quickly to any refinancing opportunities they encounter," the analysts added, while the April numbers "highlight how quickly a sharp backup in mortgage rates could dissipate the residual refinancing that has helped elevate agency speeds over the past year."

The prepayment rates of 15-year Fannie Mae and Freddie Mac collateral declined by 1.5-2.0 CPR in April, less than half the falloff in 30-year collateral. This is because smaller loan sizes, higher rate thresholds (due to faster amortization) and "the relative lack of appeal" of adjustable-rate mortgages to 15-year borrowers make prepayments on such collateral less sensitive to rate changes than comparable 30-year collateral, according to the Bear Stearns analysts.

Meanwhile, in the May issue of Short-Term Prepayment Estimates, Mr. Westhoff and analyst V. S. Srinivasan shined the spotlight on subprime mortgage prepayments.

The analysts noted that the subprime market "has undergone dramatic changes" in recent years as a result of rapid growth and an "increasingly diverse collateral mix." Subprime originations seem to have drawn from "a large reservoir" of highly leveraged borrowers with higher credit quality, they said.

"As a result, new issue subprime deals contain more borrowers with high FICO scores, high [loan-to-value ratios] and large loan sizes than seen in previous vintages," according to the analysts.

Nevertheless, subprime mortgages are still "vastly different," on average, from near-prime or prime mortgages, they declared. For example, the average subprime loan was more than $80,000 less than the average near-prime loan in 2004 and more than $276,000 less than the average prime loan, the analysts reported.

Moreover, in excess of 75% of subprime originations had prepayment penalties, while the comparable figures for near-prime and prime originations were 32% and 10%, according to Bear Stearns.

"These collateral differences make subprime mortgages much less sensitive to changes in interest rates than either near-prime or prime collateral," the analysts said.

Analyzing the link between home price growth and prepayment levels, Mr. Westhoff and Mr. Srinivasan said they "continue to believe that it is the marginal borrower's ability to access the housing market through new affordability products that is fueling much of the recent growth in home prices."

They predicted that this process will continue until one of three things happens: rates move high enough to "exert significant affordability constraints" on the housing market, demand from the marginal borrower is satisfied, or credit performance in some or all of the newest mortgage segments begins to erode.

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