Lehman Brothers announced last week that some changes were made to its conventional fixed-rate models. The changes were expected to be reflected in the bank's systems by end of business last Friday, after press time.
Analysts said that the overall impact on the Lehman Index was minimal. They added that the MBS index duration shortened by 0.05-year while the OAS remains unchanged.
In a report published last Thursday, Lehman outlined the changes for both its 30-year model and 15-year model.
For the 30-year model, Lehman had increased callability across the board to address certain issues.
Analysts said that except for 2001 cohorts the model had been slow on premiums. For instance, they stated that the model had been understating prepayments by 6% to 8% on 6.5s and 7s through 2000 vintages.
They attributed the slowness to two factors. The first factor is that the increase in refinancing efficiency since the last wave had been more than they had expected. The second factor is they had not adequately accounted for the impact of equity build-up on callability. According to analysts, this is especially important for 6s and 7s of 1996 through 1999 vintages.
With the increase in callability, the OAS on 6s through 7s drops by three to five basis points and durations drop by about 0.1 years. Lehman said that the greatest impact is on '96 to '98 originations.
Analysts added that the model has also overstated prepayments for new premiums with seasoning of less than 12 to 15 months. Over the last six months the model has overstated projections on the 2001 origination 7s by 7% CPR while understating projections on the 2000 origination 7s by 10% CPR.
Equity build-up, according to Lehman, is a major reason for this. Borrowers are short-term liquidity constrained after closing on a loan, and would not be able to come up with money for the closing costs and the escrow payments when a refinance opportunity comes along soon after the closing. To a smaller extent, another reason for this is that equity build-up, which happens with seasoning, does not adequately increase callability in the model.
To account for this, Lehman dampened the callability of new collateral with the effect of disappearing after 12 months of seasoning. Analysts said that the biggest effect of this change is on 7.5s and higher coupons where the OAS on '01 vintages will go up (two basis points for 7.5s) while '00 vintages will drop (five basis points).
Analysts said that the main issue for this model is the fact that it is not callable enough on seasoned collateral, which is caused by the impact of amortization, rather than too much burnout.
With the rapid amortization of 15-year collateral (compared to 30-year), loan balances get considerably smaller even with only five to six years of seasoning, thus having the effect of impairing callability. Lehman said that empirically this is not true. Curtailments by well-capitalized borrowers mitigate the impact of lower loan balances.
The analysts have dampened amortization's impact on callability, having the most effect on seasoned collateral ('97 and earlier vintages) where OAS tightens by two to four basis points for 6s, and 7 to 10 basis points for 7s. Durations, on the other hand, shorten by 0.1 to 0.2 years for 6s and 0.2 to 0.4 years for 7s. Lehman noted that TBA valuations remain relatively unchanged.