Fannie Mae this month adjusted its procedure for securitizing mortgages with prepayment penalties, saying it hopes to give investors more information.

Fannie is creating separate pools and classifications for mortgage-backed securities with prepayment penalties of three years and five years. Previously, its pools had a mixture of securities backed by loans with the two types of prepayment penalties.

Freddie Mac has been issuing three-year and five-year prepayment penalty loans in separate pools since it began its issuance program this year.

"Investors have told us that it would improve their understanding, and probably help the product positioning, if we could disclose more information,'' said Frank Demarais, vice president for product development at Fannie Mae.

Fannie has issued securities backed by loans with prepayment penalties since 1997. This year, it has issued $500 million of such securities per month, up from $300 million a month last year, Mr. Demarais said.

The penalties are supposed to reduce risk for investors. The loans offer consumers a reduced interest rate or lower fees; in exchange, borrowers cannot refinance or prepay for a specified period, usually three or five years.

If the loan is repaid early, the servicer collects a penalty fee. Though investors do not get any of the penalty payment, the likelihood that they will lose principal or interest income on the loans is reduced.

Prepayment-penalty mortgages are also offered in nonconventional categories such as jumbo and subprime. They are especially important for the subprime market, said Andrew Davidson, president of Andrew Davidson & Co. of New York. Such loans enable lenders to recapture some loss if these riskier loans are prepaid, he said.

The loans remain a ``drop in the bucket'' in the agency securities market, said Inna Koren, first vice president for fixed-income research at Prudential Securities. Trading in these securities has been "`sporadic at best,'' she added.

Fannie said these securities account for less than 2% of its mortgage-backed issuance. But Mr. Demarais said they offer ``slower prepayments in a down-rate environment.''

For much of the last two years, as homeowners readily refinanced, the securities have exhibited better prepayment characteristics than regular pass-through securities, Ms. Koren said. "However, I would not expect investors to pay up for this option'' in a rising-rate environment, she added.

"Typically they're not fairly valued, they're expensive,'' said Ken Boertzell, a portfolio manager for New York Life Asset Management in Parsippany, N.J. He said liquidity is the highest priority for portfolios he manages.

But Craig G. Ellinger, an associate director for mortgage-backed securities at PPM American Inc. in Chicago, said prepayment-protected collateral is now cheap in the nonagency area. Mr. Ellinger invests primarily in jumbo collateralized mortgage obligations to gain yield.

He sees buying opportunities in prepayment-protected collateral when the Treasury market sells off, as it has recently, Mr. Ellinger said. A Treasury selloff creates a good buying environment for long-term investors because some short-term investors "get complacent and forget that mortgages are exposed to prepayment and call risk,'' he said.

- Joshua Brockman

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