With the refinance boom of 2003 seemingly over, extension risk in the home equity sector will be a hot topic in 2004. Although origination volume is expected to remain somewhat constant, as lenders move up the credit spectrum, prepayment activity should decline dramatically with some seeing segments extending out by nine additional years.
There are, however, strategies investors can employ to avoid pitfalls, such as vintage and tranche selection. For example, non-accelerating senior bonds and bonds priced this year offer the best shelter from extension. The upward trend in FICO scores seen in 2003 vintage transactions is credited with bolstering newer collateral.
While supply will remain constant, refinance-driven originations are expected to decline, analysts said. RBS Greenwich Capital researcher Peter DiMartino forecasts home equity ABS volume being "virtually flat" in 2004, as many issuers focus on new growth strategies.
DiMartino notes debt consolidation as a non-interest rate-sensitive driver of mortgage originations, as well as population growth dynamics. Also, unsecuritized loans originated in 2003 could end up in 2004 home equity supply.
The majority of researchers assume a 150 basis point interest rate backup throughout 2004 as a worst-case scenario, something not seen until the second half of 2004. Using that assumption, constant prepayment rates may be cut in half going forward. Banc of America Securities researchers estimate that triple-B rated floaters, with a five-year average life at pricing, may end up as 14-year paper.
"For reasons including credit curing, expiration of penalties, [and] industry-wide competitive forces, extension risk has been minor in recent years," DiMartino said. "In that light, adverse selection had been more prominent given that those who can prepay usually do."
NAS bonds, with built-in protections from prepayments, offer an attractive alternative, BofA researchers pen in the most recent ABS SecondLook. Investors will have to pay up for the additional insulation, however. BofA's Kumar Ayier notes the 30 basis point premium on six-year NAS bonds, versus five-year sequential pay seniors. "Investors will demand sufficient spread concession for the five-year and LCF seniors compared to the NAS to take on this additional risk," Ayier writes.
Banc One Capital Market's Glenn Schultz recommends that investors avoid 2002 vintage bonds, for which "all the pieces could come together for the perfect storm of extension risk," he said. Schultz cites the relatively high prepayments that this vintage in particular has experienced throughout the year, leaving few borrowers in the pool likely to refinance as rates increase. "Given 2002 vintages current one, three, and six-month CPR and WAC, we believe that it is the most susceptible to a slowdown of one-month CPR rates on both an absolute and relative basis," Shultz notes.
While extension risk is on the radar screen for 2004, however, it is viewed as more of a late-year phenomenon. "At this point in time, monetary policy appears to be sedate with rates likely unchanged for the first three quarters of 2004. If LIBOR increases dramatically, extension indeed becomes more of an issue," Added RBS Greenwich's DiMartino. "For 2004 though, the risk will be more of an issue later in the year."