Though speeds were slightly higher than expected in the July prepayment report that came out last week, analysts say the results were a mere intimation of what is yet to come. Significant increases are predicted in the coming months with peak speeds expected in the November prepayment report.

Art Frank, director of mortgage research at Nomura Securities, said that speeds were a little faster on the 6.5% coupon, and to some extent in the 7% coupon while prepays were only modestly faster in the higher coupons. He noted that the increase in speeds in the July report was a result of earlier fallout in application activity.

"I think what happened was the June report was unexpectedly slow because there was a lot of fallout as borrowers pulled out their refinancing applications and put new ones in as rates kept falling," he said.

He added that record speeds are expected on 6s and 6.5s in the coming months. However, speeds in the higher coupons - 7.5s and 8s - will not be as fast as they were last December. Further, even though the Mortgage Bankers Association (MBA) Refinancing Index came in at only 8% below its all-time high in November, there is considerably less outstanding in the 7s and higher coupons, compared to last November. The surge in the MBA Refi Index would actually translate into even faster speeds in the lower coupons than has been seen in the past.

Frank explained that the accelerated speeds would imply that total return performance in the third quarter will not be nearly as good compared to other sectors as they were in the first half of 2002.

"In the first half of 2002, mortgages outperformed Treasurys by approximately 120 basis points - and part of that was due to spread tightening - but a lot of that was because of slower premium speeds," Frank said. "These faster speeds are going to depress the total returns of MBS over the next few months and, to the extent that we stay down here or that rates go lower still, I would expect to see some spread widening as well on 6s and 6.5s."

GNMA surprise

Analysts said that the Ginnie Mae sector is no haven in the current refinancing storm as surprisingly some GNMA cohorts - normally slower - prepaid faster than their conventional counterparts.

According to JPMorgan Securities MBS researchers, new GNMA 6.5s actually prepaid faster than their conventional counterparts. Though the researchers added that this is probably not sustainable, high GNMA premiums - 7.5s and above - are likely to stay faster than conventionals.

David Montano, head of mortgage research at the firm, pointed out that recent prepayment data indicated that premium GNMAs are prepaying faster than conventionals, even for 2001 originations. This is highly unusual. It is interesting to note that GNMA/FNMA 7s and 7.5s swaps are still trading at high premiums, despite more adverse prepayment characteristics for GNMAs.

"People are paying up for Ginnie premiums but are not getting the expected prepay protection," said Montano. "Technicals aside, we think they are vulnerable given what we are seeing in the prepayment data."

Though Ginnie Mae speeds are notoriously difficult to understand, there are some plausible explanations for this surprising trend of higher GNMA speeds relative to conventionals.

Analysts point to streamlined refinancing as well the reasonable level of servicer buy-out activity as factors in this trend. Further, Ginnie borrowers (who typically have high LTVs) are probably benefiting from a strong housing market. When home prices appreciate, LTVs decline. So if Ginnie borrowers reach an 80% LTV, they get a strong incentive to refinance into a conventional mortgage or another GNMA loan to get a refund on their mortgage insurance premium fees (equivalent to 50 basis points of annual MIP fees).

ARM effect

Various Street reports have stated that one of the more notable aspects of the July report released last week is the increase in speeds in 30-year 6.5s. The accelerated speeds in this cohort, said analysts, is proof of the effect of hybrid ARMs in the current round of refinancing (see related story on p. 15).

The conventional ARM application index is now reportedly at 6425 compared to an average of around 2500 in last year's prepayment wave. According to JPMorgan analysts, the current ARM share is the highest ever seen during a refinancing wave, even looking back on 1993 when 3% teaser rates were actually available.

Further, the appetite for the ARM product continues to rise. Countrywide Securities Corp. analysts reported that both hybrid 3/1 and 5/1 productions went up considerably in June, increasing by 57% and 80%, respectively, to $1.4 billion and $1.68 billion.

With the increasing popularity of ARMs affecting speeds on 6.5s, analysts said that this muddles the definition of what being "in-the-money" means.

"It used to be that your options were refinancing from a fixed-rate loan into another fixed-rate mortgage," said an MBS analyst. "Now it is not really clear because borrowers have other opportunities such as going into a hybrid product. The question becomes, What is your risk tolerance? Would you tolerate taking a reset risk?'"

Currently the 6.5% coupon has the largest incremental impact on prepayments. Since the 6.5% coupon also has a much greater incentive to move into ARMs, analysts say that it will be more difficult to predict prepayment speeds going forward. This is because the curve is playing a much bigger role in prepayments than it has at any time since 1993.

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