With the Mortgage Bankers Association (MBA) Refinancing Index expected to have an above 9000 showing this week, as well as further gains predicted in the near term, analysts are now expecting prepayment speeds to remain fast for the next four months. Speeds should peak in July.
Art Frank, head of mortgage research at Nomura Securities International, said that the current coupon Fannie yield at the beginning of the week of May 12 was still above 4.70. However, by last Tuesday it had gone down quite a bit to 4.44. Because of this, there is a distinct possibility that the Refinancing Index this week would exceed the 9387 record reached in March 2003.
Frank added that he is slightly lowering his prepayment expectations in the May report, although he is speeding up his predictions for the months of June and July.
"I'm slowing May a little because I think we are going to see more fallout," he said. "August is still three months away so speeds for that month would depend on where rates go from here, but I think fast speeds for June and July are already in the pipeline."
He said that he does not expect the Refinancing Index to far exceed its record high achieved in March because the broker community would probably not be able to handle this much business. He also does not expect prepayment speeds to reach the 90-CPR mark.
"I don't think that that overall speeds would reach 90 CPR or even 80 CPR," said Frank. "They would likely peak in the high 70s in the most prepayment-sensitive Fannie and Freddie coupons."
He predicts increases in 5.5s and 6s. He cited 30-year 5.5s and 15-year 5s as sectors that would most likely experience the largest increases. However, he does not expect 30-year 5s and 15-year 4.5s to speed up significantly.
Meanwhile, JPMorgan Securities last Wednesday said that they are expecting 6 WALA and older 30-year 6s to prepay at about 70% CPR by July, with 6 WALA 30-year 5.5s prepaying at around 40% to 45% CPR. Meanwhile, Dwarf 5.5s could probably prepay at 70% to 75% CPR while Dwarf 5s could prepay at 50% CPR by July. Prepayments on Dwarf 6s could be around 5% CPR slower than Dwarf 5.5s. JPMorgan added that these prepayment speeds would imply that rolls on 30-year 5.5s and higher actually have room to collapse from current levels.
Looking for a place to hide
With breakneck speeds up ahead, portfolio managers are currently bracing for more liquidations, said analysts.
At this point, Frank said that the right investment strategy is to roll current coupon and buy specified pools with better prepayment characteristics in the higher coupons. In 5.5s and 6s, he likes low WALA pools, suggesting buying pools with an average loan age of just one or two months. With 6s and 6.5s, he suggests moving into low loan balance pools. However, if there isn't enough low loan balance collateral, Frank suggests moderately low loan balance pools (average balances ranging from $75,000 to $100,000). He added that geographic regions are still a factor to consider. For instance, New York collateral tends to prepay at slower rates while loans from the Illinois tend to prepay especially fast.
Kevin Jackson, vice president at RBC Dain Rauscher, said that based on conversations with portfolio managers, investors are now staying away from premium prices and fast servicers because of the anticipated surge in prepayments in the coming months. Some of the strategies Jackson mentioned include looking for short average life structures with good spread at the front end and minimal WAL drift, and moving into specified pools and money market alternatives (i.e., one-month LIBOR floaters).
He added that discount last cash flow sequentials are currently the popular choice for insurance companies. Pure cash flow buyers have also taken to buying balloons in size for extension protection.
Analysts said the dominant theme in the mortgage market right now is that there is almost no duration. This is why investors with fixed liabilities (such as insurance companies) would probably have to lighten up in mortgages and do a higher percentage of investing outside of mortgages.
"If you look at the coupon swaps, the difference in price between 5.5s and 6s is only 9/32," said Frank. "So the difference in price between 6s and 6.5s is only 10/32." He added that the difference in the price of TBA in Fannie 5.5s and 6.5s is only 19/32, which demonstrated very slow premium durations.
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