There has been much discussion on the Street about the impact of home price appreciation on prepayment speeds, with many analysts predicting a slowdown for the housing market this year.
JPMorgan Securities analysts looked at the impact of the housing market on prepays in a recent report. They examined whether a slowdown in housing, along with a flat yield curve, will lead to a meaningful deceleration of current discount speeds.
The firm examined existing home sales that have never dropped by more than 1/2 of a CPR since 1990, since analysts have long said home price appreciation and existing home sales growth are weakly correlated. They reiterated their view that rising homeownership - which is largely driven by younger, more mobile, borrowers - has caused a fundamental shift in the mortgage market. This implies that baseline turnover could stay near 9% CPR, equivalent to 50 basis points out of the money, even in a soft housing market. This is why JPMorgan strongly disagrees with comments made by other Street analysts who say existing home sales are somewhat inflated because of a strong housing market.
By using state-level data and sampling the 1991-2005 period, JPMorgan observed that there is a slight negative correlation between housing market growth and existing home sales growth in states like California. In an already inflated housing market, analysts said a modest depreciation might stimulate activity by motivating sellers with considerable gains and adding buyers who were locked out of the market. Conversely, homes could appreciate to the point where affordability is impacted and existing home sales drop since there are fewer buyers, which is a precursor to depreciation. Affordability has been sustained longer in the current environment with the growth of IO loans. Analysts said affordable lending, increasing homeownership as well as younger and more mobile borrowers are the drivers of higher existing home sales.
Demographics, economic health' are significant
"Fundamentally, demographics and overall economic health [employment] may be better indicators of [existing home sales] than either interest rates or home price appreciation," JPMorgan analysts wrote.
Though existing home sales might be stable, that does not mean prepays will remain unchanged by a softer housing market, JPMorgan analysts wrote. Cash-out activity would probably dip significantly as a result of both weaker home price appreciation and an inverted yield curve. The compression in speeds should be most seen for at-the-money coupons. With so many affordable lending products, fixed-rate borrowers have more options now compared to 2000 and 1994, likely resulting in less lock-in for amortizing loans. There is probably going to be a flattening in the prepay curve for coupons that are near par, with a very sharp rise in prepays for 50 basis point incentives or more.
In a weaker housing market, the difference between at-the-money speeds and existing home sales should narrow from the 6% CPR seen in 2005 to the more historically normal three to four percent CPR range. Markets that have experienced considerable appreciation - California, Nevada, Florida and New England - have no structural impediments to mobility and could show the greatest drops in at-the-money speeds. But analysts expect the pace to be slower, playing out over most of this year and in line with any slowing in the housing market. At-the-money prepays have been considerable above existing home sales since 2000. This was mainly a result of a rise in cash-outs and affordable lending products such as IOs and option ARMs.
"In a softer housing market, we expect that seasoned at-the-money speeds could revert to 12% CPR," JPMorgan researchers wrote.
In a separate report, Citigroup Global Markets analysts said considering that housing turnover seems to have slowed considerably beyond what the drop in mortgage rates might imply, one would expect prepayment speeds, even after adjusting for the level of disincentive (lock-in), to exhibit a corresponding slowdown as well. Data presented by Citigroup analysts reveal that some slowing has occurred, though it seems to have happened in seasoned collateral compared to new collateral. This pattern is also implied by state speeds manifesting comparatively higher California and Florida CPR ratios to the U.S. average for new collateral speeds compared to corresponding CPR ratios for seasoned collateral.
Citigroup analysts concluded that though it is hard to measure summer to winter speed changes considering the uncertainty of seasonal factors, and uncertain lags make it tough to adjust for relative coupon, the effect of the housing slowdown implies that seasoned collateral speeds might have been impacted by more than new collateral. This is consistent with declining cash-out refinancings that are driven by weaker home price appreciation, though it is inconsistent with a drop in flipping/trade-up activity that could also be linked to weaker home appreciation.
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