Prepayment speeds in August are anticipated to increase around 10% to12% overall in 30-year MBS as there are three more collection days in August compared to July. September is expected to see slowing of around 10% to 15% primarily due to a lower day count, while speeds in October are seen as flat to slightly higher. This recent rally is leading to slight upward revisions in speeds in September and October, particularly for the higher coupons.
Bear Stearns Senior Managing Director Dale Westhoff believes that while the current slowing in the housing market is a healthy development, the correction does have important implications for MBS cash flows for the remainder of the year and into 2007. Specifically, he stated that, "highly leveraged borrowers that were supported by ever increasing home prices and a long menu of low payment, cash-out refinancing alternatives will likely exhibit the greatest extension risk over the next 12 months as the repeating cycle of equity build-up and cash-out refinancing finally ends."
To demonstrate this, Westhoff points to San Diego where home price appreciation dropped from a peak of 30% in 3Q04 to just under 10% currently. Looking particularly at the subprime sector, he finds that purchase loans are paying 50% slower than comparable cash-out loans. In the previous high-HPA environment, purchase loans were paying similar to cash-out loan prepayments after the first year. "The takeaway from this analysis is that as the housing market transitions to an environment of low or stagnant HPA, we believe that extension risk becomes concentrated in borrowers with more leverage," Westhoff said.
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