With rising interest rates still expected, market participants remain worried about extension risk on discount loans.

This is why analysts from Deutsche Bank Securities asked, "Will the turnover levels stay high or will discount mortgages experience speeds below 100% PSA and impose significant extension risk?"

In a recent report, DBSI looked at jumbo loans in particular focusing on historical speeds on Jumbos in high interest rate environments - because this sector is perceived to have greater convexity versus their agency-backed counterparts.

Analysts found that although prepayment speeds will eventually decline as rates inevitably rise, higher mortgage rates would not single-handedly lead to turnover levels below 100% PSA. The report stated that the important contributors to elevated turnover are housing prices and economic expansion.

"Higher rates by themselves should not lead to a slowdown in prepayments," said DBSI MBS analyst Victoria Averbukh. "What is needed, in addition to higher rates, is a depreciation or prolonged stagnation of the housing market."

Analysts believe that although the current level of home price appreciation is not sustainable, the housing market is not likely to experience prolonged stagnation as economic growth and strong labor markets should keep turnover rates steady.

"We agree that the level of mortgage rates plays an important role in borrower's ability to afford a house, thereby impacting housing prices," analysts wrote. "However, rates are not the only significant factor."

This is evidenced by California median housing prices and weekly current coupon yields. In this case, not all periods of rising rates led to a recession in the state's housing market. Analysts noted that although high mortgage rates in 1994 to1995 coincided with price drops, this did not hold true for the 1989 to1990 or 1999 to 2000 periods. Also, while historic low rates in 2002 to 2003 coincided with robust housing prices, this did not apply from 1992 to 1993.

Deutsche expects the 10-year Treasury yield to reach 5% and net mortgage rates to hit 6% in the next 12 months, merely 75 basis points over current levels. "Such an increase is highly unlikely to result in a serious downturn in the nationwide housing market, or even in California," added analysts. Without a serious dent in housing, analysts believe that stable home prices - even in areas that are seen as bubbles - will continue supporting discount prepayment rates.

So even if a considerable amount of recently issued Jumbo collateral quickly becomes discounted due to rising rates, Averbukh maintains the sector's cheapness and current relative value, adding that investors are currently overestimating extension. Analysts anticipate that even if mortgage rates increase considerably, discount Jumbo speeds will average 120% to 150% PSA over time. "Stress-testing CMOs with long-term speeds of 100% PSA or below is unrealistic, and overly conservative investors are likely to be leaving money on the table," they wrote.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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