As the housing market is rapidly changing and the vast majority of coupons in the mortgage market are trading at a discount, analysts at Barclays Capital explored the factors driving discount speeds in a quest to find ways to get protection from extension risk.

"We think that higher mortgage rates and a weakening housing market are likely to reshape the prepayment profile of many discount pools," Barclays analysts wrote. "In the new environment, seasoning ramps are likely to extend materially...many pools that have provided excellent extension protection in the past are unlikely to continue to do so."

The two main factors driving discount speeds are existing home sales and home equity extraction. Over the past several years, while mortgage rates were particularly low, home equity extraction was important for determining discount speeds. In the current high rate environment, however, existing homes sales should be the main driver of discount speeds as homeowners are unlikely to carry out non-economic cash-out refinancing.

Support for this hypothesis is evident in an examination of changing rate environments from 2000 to the present. In 2000, in a high rate environment, discount speeds were strongly correlated with the level of existing home sales. In the past year and a half, though, there was only a weak correlation with home sales, suggesting that discount speeds in 2005 were driven by factors such as home equity extraction.

"While record levels of home price appreciation created a disconnect between home sales and discount speeds in 2004/5, higher rates and a slowing housing market should cause prepayments to track home sales more closely in 2006/07," Barclays analysts said. "This transition towards a high rate environment has substantial implications for relative value across discount pools. Under these circumstances, states with strong existing home sales should have the best extension protection."

In California, for example, discount pools have been significantly faster than the national average over the past few years thanks to a strong housing market and home equity extraction. However, its existing home sales have been relatively weak compared to the rest of the U.S. during the past year, suggesting that discount speeds should prepay substantially lower than the national average in a high rate environment. On the other hand, states like Texas, for example, that have been slower in comparison with others over the past few years, will become faster than the national average in a high rate environment due to strong existing home sales, the Barclays report said.

(c) 2006 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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