With higher mortgages rates compared to lows seen in the middle of this year, analysts said that the September report should show the most significant drop in prepayment speeds seen this year.

"There should be a pretty significant decline in September relative to August," said Steve Bergantino, vice president for mortgage research at Lehman Brothers.

In August, approximately $100 billion of 30-year conventionals prepaid. Lehman estimates that September prepayment volumes will be between $50 billion and $60 billion, a 40% to 50% decline from August. In terms of prepayment speeds, the benchmark cohorts 2002 5.5s and 6s would likely see the biggest drops. In August, 5.5s prepaid at 47 CPR and 6s prepaid at 66 CPR. Bergantino said that he expects prepayments on these cohorts to come down by 20% to 30% CPR.

He explained that recent-origination 5.5s are the cohorts that will see the largest declines. First, the average WAC on 5.5s is about 6%, while the average mortgage rate reflected in September prepayments is about 5.9% (50 basis points higher than in August). Thus, unlike higher coupon cohorts, 5.5s have seen their opportunity to refinance into a lower rate all but disappear.

Moreover, because the borrowers backing these newer cohorts chose 30-year fixed-rate mortgages despite the steep yield curve environment in which they were originated, they are less likely than more seasoned cohorts (e.g. 2001 and 1998-99 originations) to take advantage of the more than 100 basis point rate advantage offered by hybrid ARMS.

On the other hand, even at current mortgage rate levels the more seasoned premiums, such as 6.5s and 7s, still have a rate incentive of 100 to 150 basis points. "These cohorts still have a fairly significant incentive to prepay," said Bergantino. "Moreover, since the borrowers backing these cohorts chose 30-year mortgages at times when the rate advantage of hybrid ARMs was much less than it is today, they are more likely to take advantage of this option than more recently originated cohorts."

In terms of Lehman's extended forecast, an earlier report said that if rates stay at the 5.90% to 6.25% range as they have been over the last two months, any additional drops in prepayments in October or November should be considerably smaller than what is expected for September.

For example, Bergantino said that 2002 5.5s are estimated to go down from 47% to 20% CPR or lower, which is close to a 30% CPR drop from August to September. Lehman is expecting this coupon to prepay between 12% and 15% CPR for the October report, which is only a 5% to 10% CPR drop. Prepayments on this coupon would probably stabilize in November and December with day counts having more of an effect than anything else.

Prepayments on higher-coupon seasoned collateral should also decline in the next few months, but, without any further rise in mortgage rates from current levels, these coupons will continue to reflect reasonably high levels of refinance activity - 40% CPR and upward.

The next landscape

In a Merrill Lynch report released last Wednesday, the bank also projects that September should see the biggest drop in prepayment volumes. Last month, fixed-rate agency prepayments plunged from above $200 billion to an estimated $163 billion, analysts said. This month they expect about $97 billion.

"This figure of $97 billion in prepayment volumes would be consistent with prepayments on the lower coupons like 5.5s and 6s falling around 20% to 25% CPR along with far smaller drops (3% to 6% CPR) on higher coupons such as 7s and above," wrote analysts.

They said that after the big decrease in prepayments in September, prepayments should stabilize somewhat, providing that the market also stabilizes. Merrill said that the current coupon yield is now about 5.30%, which is where it was in November to December 2002. Looking at prepayments last January and February (considering these rate levels), 6s of 2001 were prepaying at approximately 42% CPR while 6.5s were prepaying at 59% CPR.

The market has to take into account factors that are present today that might push speeds higher or lower. They said that burnout is a major factor that might dampen speeds. Aside from this, there may be less media attention paid to lower rates.

However, it is possible that less volume could drive primary/secondary spreads to narrow, which would, in turn, lower mortgage rates, said Merrill analysts. Also, a steeper curve could create more borrower movement into ARM refinancing.

The bank expects prepayments on 2001 6s to stabilize in the area of 35% to 45% CPR while prepayments on 2001 6.5s will likely stay in the vicinity of 50% to 55% CPR. Merrill adds that there should be a margin for error considering the competing factors mentioned. Meanwhile, 2002 vintages are expected to prepay 7% to 9% CPR slower compared to 2001 vintages.


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