With the increased Freddie Mac and Fannie Mae prepayment speed differential, investors are overcompensating, particularly in the 30-year sector.
In recent research, Bear Stearns compared the current situation to the historical Fannie/Freddie prepayment relationship, to determine whether the market's price adjustment is warranted - and Bear found that the market is overestimating the short-term prepayment difference.
Bear analysts argue that, although collateral characteristics and geography remain the primary drivers of prepayment rates, there are some differences existing across servicers in brand-new pools, particularly for those under 12 months old. To determine whether any systematic differences emerge on this basis between Fannie and Freddie, analysts compared the "refinancing curves" for new pools (zero to 12 months seasoned) to those of slightly seasoned pools (12 to 30 months seasoned) over the last four refinancing cycles.
Bear found that the current situation is not unique. During the last three refinancing cycles, the Freddie refinancing function is significantly steeper in the initial 12 months and then very similar thereafter. However, in the 1998 refinancing wave, there were actually no significant differences that emerged between Fannie and Freddie collateral.
So the next question becomes: What happened between 1998 and 2001 that resulted in this change? It should be noted that in 1999-2000, large originators started to align themselves exclusively with Fannie or Freddie. Thus, any significant variations in prepayment performance between originators were actually seen as differences in Fannie/Freddie prepayment speeds after 2000. This is why the increased concentration of Wells Fargo and ABN Amro collateral in Freddie pools contributed to the structural change in prepayment behavior.
So what do these mean for investors? Bear said that Freddie collateral has a tendency to manifest higher refinancing rates over the first twelve months. Analysts also stated that Freddie's 5.0% TBAs are trading on par with Fannies, and 5.5% TBAs are trading four ticks cheaper than Fannies. Given the delay differences between Fannie and Freddie, the current prices reflect a three- and seven-tick discount for Freddie compared to Fannie 5.0% and 5.5% TBAs. Therefore, since investors will not likely be delivered zero WALA paper (for premium coupons at least), these price reductions make Freddie collateral cheap.
Bear also noted that prepayment differences past the 12-month period are not really significant. Thus, as a pool seasons, Freddie and Fannie prepayments should converge. In light of the recent price spread correction between Fannie and Freddie collateral, it seems that the market may really be over-correcting for the actual short-term prepayment difference. This is why there is value (versus Fannie collateral) in Freddie MBS that are nearing the end of their ramp.
Separately, in an unusual move, Freddie Mac stated that it is committed to ensuring that Gold PC prepayments are "consistent with market norms." The release also enumerated three specific ways in which Freddie Mac would achieve this goal (see related story on p. 17).
Prepayment analysts talked about the importance of this move. "I think it is crucial for Freddie's business that Gold passthroughs prepay fairly similarly to Fannies," said an MBS analyst. "Freddie Mac would have to take some action to narrow that differential."