Increased prepayment speeds paired with limited reinvestment opportunities have led to spread compression in the European RMBS market of late, but a lack of prepayment data remains a hindrance that needs to be explored. Fitch Ratings held a conference call last week investigating the dynamics of prepayment drivers in European RMBS and prepayment behavior analyses on a country-by-country basis.

According to Fitch, European investors are finding what U.S. investors have long experienced: Unpredictable prepayments make it difficult to predict the average life of a transaction. For the first time, European investors are seeing the accelerated return of principal resulting from a higher prepayment-rate environment.

"Voluntary prepayment is highly dependent on country-specific, competitive and cultural factors," Fitch said. There is a limited distinct relationship between prepayment rates and the variables stressed by Fitch in the different rating scenarios such as interest rates, defaults and general state of the economy, the rating agency noted.

Prepayment rates historically have been more of an issue for fixed-rate, long-term mortgage products, but it has increasingly moved into the spotlight for floating-rate pass-through RMBS paper in Europe. Compounding the issue, obtaining good, reliable data for European deals is not easy at the moment. "Good, consistent CPR data on outstanding deals in the European market is very difficult to obtain at present," reported analysts at Dresdner Kleinwort Wasserstein. "Although a number of servicers/originators do report a figure, the methodology behind it is often in-transparent."

Fitch analysts added that countries with higher refinancing costs have historically demonstrated lower prepayments and that the rate of prepayment volatility tends to be heightened in jurisdictions restricting fixed-rate mortgages, as is the case in Belgium and the Netherlands.

In Belgium, for example, prepayments have remained historically low, with borrowers locked in by hefty prepayment penalties. However, the interest rate environment could be enough to persuade borrowers to refinance out of a loan, as was the case in 1999, when rates fell to all-time lows. Analysts said that despite penalties, interest rates were attractive enough to entice borrowers into refinancing.

Although Fitch estimates rates on a country-by-country basis, there is a margin of leading indicators that can be applied in most markets to better understand prepayment behavior. The refinancing costs on mortgage loans are one consideration that typically might prove burdensome in countries such as Belgium that offer longer, fixed-rate terms. However, lower interest rates can influence choice as well, and there is growing competition among lenders catering to borrowers looking for more competitive terms.

In the U.K., where loans come with more lenient refinancing terms, borrowers tend to be acutely aware of home prices, said Fitch analysts, and appreciation drives borrowers to seek out an equity release through refinancing. "There's been a considerable easing of prepayment rates since the last recession in the U.K.," said one analyst. "Interest rates have influenced borrowers, but there are other features of the market that have driven the rise in prepayments."

In the U.K., where prepayment fees are usually applicable only during a short teaser period - typically 1.5 years - borrowers will always be interested in looking at competing loans, said the analyst.

Understanding prepayment scenarios is critical to evaluating how this product behaves in the market. On new issues, investors need to be aware that a pickup in prepayments from the modeled CPR drives premium bonds down. "We reiterate that CPR assumptions remain a critical part of evaluating RMBS in the secondary market," said analysts at JPMorgan Securities. "We found out the many European RMBS transactions are prepaying much faster than their [initial] pricing CPR assumption."

For example, HERMES 5, which priced in 2002 at 10% CPR, actually is prepaying at 16% to 20% CPR. Assuming the triple-A tranche is currently trading at 100.51, the spread to three-month Euribor is 15 basis points at 10% CPR, and 10 basis points at 20% CPR. "Using the pricing spread can overstate the triple-A tranche's discount margin by over five basis points - investors should look at transaction performance and use current CPR to evaluate the bonds," said an analyst at JPMorgan.

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