The hybrid ARM product is currently readily available to borrowers at attractive rates versus the 30-year fixed sector - creating an additional refinancing incentive. This phenomenon has pushed discount prepayment speeds significantly upwards, compared to what had previously been seen.
"While discounts used to prepay well below 10% CPR in a sell-off, the recent experience has been much faster," said Morgan Stanley analysts in a recent report. The 1999 to early 2000 vintage experience demonstrates this well. During that period, 6.5s from 1998 - roughly 120 basis points out of the money - slowed down to 5% CPR in the beginning of 2000. Furthermore, even 1998 7.5s, which were just slightly out of the money, prepaid approximately 10% CPR.
However, discount prepays have been much faster than what the 2000 sell-off indicated. For instance, analysts said that 2003 vintage 5s have prepaid slightly faster than 11% CPR, despite the fact that this vintage is about 60 to 70 basis points out of the money. Meanwhile, even with the slightly negative refinancing incentive, prepays on 2003 5.5s were roughly 15% to 17% CPR.
Morgan Stanley attempted to identify the causes of the comparatively fast prints on 2002 and 2003 discounts. First of all, researchers pointed out that there are currently not as many cashouts compared to a few years back, thus this factor cannot be the cause of fast discount prepayments. Instead, analysts said that the refinancing incentive has increased for discounts versus the current level of mortgage rates. Because of this, the notion of "out of the money" should not be the same at it was in 2000.
In the report, analysts also looked into the "hybrid temptation," pointing to the gapping out of hybrid rates and 30-year fixed rates, also noting that hybrids could currently be offered at very attractive initial rates due to the steep yield curve. The data proves that "the spread between hybrids and 30-year mortgage rates has been quite wide recently, and that 30-year borrowers have not been prepaying into new 30-year loans as much as they used to," researchers wrote.
The report also discussed the probable effect of a flatter yield curve on discount prepayments. Analysts report that if the yield curve flattens significantly, and if the ARM/hybrid/fixed-rate curve follow suit, discount prepays are expected to slow down considerably.
However, they also noted that higher rates on hybrids could cause the attractiveness of financing a new home to be greatly minimized, concluding that a flatter curve could adversely impact housing affordability. This would cause the reduction in cashout incentives as well as lowered turnover speeds. "In such a scenario, the prepayment speeds on discounts observed in 2000, which reflected a healthy housing market, would likely be upper bounds," Morgan Stanley analysts added.
Considering this, Morgan Stanley thinks that the prepay behavior of current discounts is largely dependent on the slope of the curve. In other words, a flatter mortgage curve, even with constant 30-year rates, would have significant impact: no more refinancings out of discounts, limited cashouts and slower housing turnover.
Separately, Art Frank, head of mortgage research at Nomura Securities, said that current housing turnover - which drives discount speeds - is now faster compared to the 1994 to 1995 period. He enumerates three reasons for this. First is the Taxpayer Relief Act (passed in August 1997). This law changed the capital gains tax treatment for primary residences. Since August 1997, married couples filing jointly can exclude up to $500,000 of capital gains on the sale of their primary residence, even without moving to a larger house, if the house served as their primary residence for at least two years.
The second reason he cited was that current borrowers have accumulated significantly more equity in their homes compared to 1994, and thus are more likely to move. The third factor is increased homeowner mobility. Ten years ago homeowners were expected to move about every 12.5 years, which is equivalent to only 8% CPR. Currently, borrowers expect to stay in their homes for a shorter period, nine to 10 years on average, corresponding to 9% and 10% CPR, respectively
There are two areas that are exhibiting exceptionally fast discount prepayments - GNMAs and 2003 production, Frank said. GNMAs currently exhibit characteristics associated more with subprime collateral. This factor has caused defaults to become more common in GNMA product, and has added a couple of CPR to speeds in the sector. Aside from this, because FHA/VA borrowers currently have lower LTVs due to home price appreciation, many of them have qualified for a conventional loan. This has increased refinancings out of GNMAs to conventional product, noted Frank.
Additionally, 2003 production has more embedded seasoning because the collateral is made up mostly of refinancings. Thus the homeowners backing these pools have lived in their houses longer compared to purchase mortgages and, as a consequence, have a greater propensity to move.
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