Analysts have identified burnout in seasoned higher-rate mortgages as a source of last week's drop in the Mortgage Bankers Association (MBA) Refinancing Index.

In a report, Countrywide Securities said seasoned high coupons usually experience less sensitivity toward refinancing opportunities right after a refinancing wave - which is more simply known as prepayment burnout. Heavy refinancing activity usually eliminates higher-quality borrowers from the pools, leaving borrowers with credit issues or non-appreciated homes. Lack of financial sophistication may also be contributing to a segment of borrowers not leaping for the refi incentive.

This movement into a burnout phase is part of a cycle. After an extended period, burnout turns into what Countrywide analysts call a "recharge phase." They explained that in the years between bouts of heavy refinancing activity, a portion of the pools' borrowers are able to fix credit problems. Home price appreciation can also improve a borrowers' creditworthiness and ability to refinance. By the next refinancing wave, the pools are "reenergized" by the two factors already mentioned, plus a publicity effect from low interest rates. All of these facets bring the sector back into a fast prepayment regime, analysts stated.

Countrywide said that the key question for investors currently is whether seasoned premiums are caught in the onset of a new burnout phase. This would be good news for potential investors, as it would suggest slower prepayment speeds than those seen for most of 2002 to 2003. Aside from this situation, seasoned high coupons are expected to prepay more slowly than their newer production counterparts.

It's only just begun

In the report, analysts theorized that a burnout phase in this sector might have actually started late last year.

"In terms of historical precedent, the prospects are good: the refinancing wave of 2002-2003 witnessed the enormous draining of high-coupon pools," wrote analysts. Also, the new 30-year mortgage rate has held for several months in a range 45 to 85 basis points above last year's lows, lessening refinancing incentives. Refinancing activity, though still fairly robust, is a mere fraction compared to last year's peak.

Analysts also supported their theory about the recent onset of burnout by comparing recent prepayment behavior of seasoned premiums versus newer originations. Paul Jacob, an analyst from Countrywide, said that analysts are looking at how 1998 6.5s are prepaying versus newer production 2001 6.5s. He said that at the peak of the refinancing wave last spring and summer, the older bonds were prepaying just as fast, if not a little faster, compared to newer collateral. "In recent months, while everything has been slowing down some, we've seen a greater degree of slowdown in the older pools," said Jacob.

Apart from this development, in the long term most fixed-income investors think that interest rates will rise by the end of the year. "This highlights one of the more attractive aspects of seasoned high coupons in a burnout phase: seasoning represents the rare category of convexity MBS whose pay-ups tend to rise relative to TBAs when interest rates rise," it was noted.

Refi index as a burnout indicator

In a separate report, JPMorgan Securities said that the current level of the MBA Refi Index implies a slower-than-expected pickup in prepayments for at least a month. This is more surprising, analysts said, especially since their estimate of the level of the Index is understated; the greater share of ARM originations and the hybrid effect are not even considered in JPMorgan's analysis.

"Given how the share of hybrid ARMs as a percentage of the overall mortgage market has grown, the Refinancing Index reading should have been higher than implied, since our analysis of the refinanceable universe consists solely of the fixed-rate conventional mortgage index," stated analysts. They added that a steeper curve implies a greater incentive in terms of hybrid rates, thus resulting in a higher Refinancing Index from 2002 to 2003.

JPMorgan data shows that the size of loans being refinanced has increased in the last four to six weeks. The report observed that the absolute size of refinanced loans - including hybrids and Jumbos - has been greater than the average outstanding conventional loan. However, analysts said that the ratio has been inversely correlated with the share of refinancing loans. In other words, as refinancing activity builds, older (smaller) loans refinance, and this ratio goes down.

Beginning in the early part of 2002, the initial pickup in prepays has been led by a rise in this ratio, with larger loans (which were led by newer originations) quick to refinance. The rise in the average size of a refinanced loan was followed by a considerable dip in the ratio of loan sizes. This phenomenon was led by two factors - an increase in the pace of older loans refinancing and a rise in outstanding loan size as new originations came in.

In the past four weeks, however, there has been an observable increase in this ratio, which suggests that refinancing is being driven by newer loans - a phenomenon that analysts said deserves close attention. "If an increase in refinancing activity is not preceded by a decrease in this ratio, it would suggest that there are clear signs of burnout among premiums," JPMorgan analysts said.

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