With mortgage rates recently rising above 7%, concerns are increasing over extension risk as supply and prepayments are bound to decrease substantially.

In a recent report by UBS Warburg, analysts said the past year taught the market a lot about refinancings but not a whole lot about extension risk. They added that with over 38% of the market in 6.5s or lower, a back-up in rates as well as a recession on the housing front could lead to speeds below 100% PSA.

According to other analysts, what eventually would emerge as an arbiter of value in the mortgage market is how much seasoning one has in the low coupons. Seasoning in the low coupons would entail more embedded appreciation and would mean less exposure to extension risk, as embedded appreciation would allow for greater housing turnover.

In the Dec. 3rd issue of ASR, experts warned that the risk from extension is not so much from just extending duration but it is more from a potentially significant decline in turnover rates.

However, as current production is dominated by refinancings, in a few months, if rates stay at current levels, future production is going to be dominated by people taking out loans for new home purchases. These types of loans do not have the embedded appreciation in them, thus making them vulnerable to extension risk. Making matters worse, home prices are currently not rising as rapidly as they have been over the last four years and this will certainly affect how fast the discount speeds are.

Importance of models

Analysts said that with the threat of extension risk, the importance of an accurate prepayment model becomes more apparent.

A good prepayment model would give market players a sense of how much rates are going to increase, what prepayment speeds are going to do down the line and how they will affect the duration of the securities an investor owns. This would, therefore, give them an idea of how to hedge extension risk.

In today's refinancing wave, a good model would include housing appreciation data. This is because the most recent refi boom was fuelled by both home price appreciation and low interest rates.

While there is a precedent to hedging extension in a low-interest rate environment, there is no prior experience in hedging prepayment risk when there is a possibility of a decline in home prices after an era of rapid home price appreciation.

"If your prepayment model doesn't have the home price appreciation part built into it, and home price appreciation slows down and it makes securities extend more, you might have a problem with hedging," said an MBS analyst.

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