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Prepayment Rates Hold Steady in August

Agency MBS speeds held steady for 5.0% and 5.5% coupons but rose as much as 12% for higher coupons in August, strength largely attributable to the number of business days, according to Bear Stearns & Co.

Bear Stearns analyst Dale Westhoff said the "strong numbers" resulted from the three additional business days in August, which he said "clearly offset" the rise in mortgage rates that took place during that time.

The speeds of discount mortgage-backed securities maintained their record pace in August, Mr. Westhoff said, pointing to the rise of the huge 2003 vintage 5.0% coupon from a constant prepayment rate of 18.4 CPR in July to 19.1 CPR.

"This pace continues to be over 50% faster than historical averages and reflects rising home prices and vigorous cash-out refinancing activity," Mr. Westhoff said. "It is important to note that so far the massive flattening in the yield curve has had little impact on discount/current coupon MBS prepayments."

The Bear Stearns analyst said the only somewhat surprising aspect of the August report was the higher-than-expected speeds of some seasoned coupons above 5.5%.

"To some extent the surge in seasoned coupon prepayments this month offset their muted response to stronger incentives last month," he said.

Mr. Westhoff said speeds are likely to slow significantly in September.

Meanwhile, in the September issue of Short-Term Prepayment Estimates, Mr. Westhoff and two other Bear Stearns analysts maintained that the durations of MBS portfolios are likely to lengthen significantly if home price appreciation retreats to something like its historical norm.

A reversion to home price growth comparable to the rates in 1999 and 2000 (a nominal rate of 6.7%, and a real rate of 3.4%) would "produce a commensurate slowing in aggregate discount prepayments from today's 13 CPR level to approximately 9 CPR," say analysts Dale Westhoff, V. S. Srinivasan and Steven Bergantino.

The analysts said today's extension situation is "very different" from that of 2003, when a sharp rate increase "shut down the rate/term refinance pipeline."

"In 2003," the analysts said, "relatively small changes in rates could produce very large changes in mortgage duration, as large and concentrated blocks of mortgages moved out of the rate/term refinancing window. Today, with the bulk of the mortgage universe outside of both the fixed and ARM refinancing windows, extension risk is much more levered to the performance of the housing sector and the ability of borrowers to continue to cash out equity."

As a result, investors need to realize that extension risks are tied less to interest rates and more to the performance of the housing market than in the past.

The Bear Stearns analysts noted that the mortgage market has undergone a transition since 2001 from one in which ARMs account for about 10% of mortgages outstanding to one in which they represent about a third of mortgages. Traditional fixed-rate borrowers have moved into the ARM sector because of cash-out/affordability considerations or because an ARM "matches their expected tenure," the analysts said. As a result, the fixed-rate sector has become dominated by borrowers with longer time horizons.

"Although in the short run this transition has driven fixed-rate prepayments much faster than we have seen historically, in the long run it ultimately conveys more extension risk to the fixed-rate universe as the borrowers with the shortest horizons and greatest refinance sensitivity exit fixed-rate pools for ARM pools," the analysts said.

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