Morgan Stanley introduced its new student loan ABS prepayment model last week, determining that some shorter student loan paper looks cheap versus longer dated supply. By using a different calculation of projected prepayment activity, the model provides a way of looking for value opportunities in the sector.
Examining historical prepayment rates across non-consolidation vintages from 1998 through 2004 and isolating three main explanatory variables, quarter-by-quarter seasonality, weighted average maturity and the Treasury bill rate, Morgan Stanley found that T-Bill rates are the primary driver of consolidation, rather than the T-Bill to WAC spread.
In explaining their methodologies for each variable, Morgan Stanley researchers noted the seasonality variable includes a higher multiplier for the third quarter, as consolidations surge prior to the mid-summer rate reset. In terms of weighted average maturity, older loans also have a tendency to outpace even consolidation-driven prepayment rates, because many of those borrowers have sufficient income to repay their loans in full.
The researchers found that consolidation incentive for SLABS cannot merely be measured as the difference between T-Bill rates and the coupon of the pool, as is often the case with mortgages. Morgan Stanley instead suggests that prepayment rates for SLABS are driven mostly by the actual T-Bill rate. Morgan Stanley uses a T-Bill rate of 6% as the inflection point for when CPR levels off.
Morgan Stanley took those three variables and ran them against three different T-Bill rate scenarios. The slow rise scenario plots the T-Bill rate at 25 basis point annual increases over five years to 4.25%, the medium rise scenario calls for a 50 basis point annual increase over the same period to 5.5%, and the fast rise assumes a 100 basis point annual rise to 8% over five years.
The model develops a statistic called the quarterly conditional prepayment rate, which measures prepayments between quarterly coupon payment dates, and converts it to life-to-date CPR. To run cashflow analysis, Morgan Stanley notes the optimal variable to use is projected LCPR, which it uses in its model, versus historical LCPR, found in remittance reports.
Historical LCPR tends to underestimate prepayment speeds, because it is based on prepayment measurements before consolidation has kicked in and is "basically useless" in predicting future CPR. Projected LCPR, on the other hand, is specifically concerned with predicting future projected balances.
Overall, the firm recommends looking for shorter dated bonds with a larger spread pick-up relative to smaller degrees of average life variability under large changes in CPRs, exhibiting spread pick-up to new-issue spreads for similarly tenured securities. To illustrate this, the firm examined a 1.6-year bond pricing at 25 CPR, that slows to 10 CPR and extends to 2.4 years. Accounting for a nine basis point spread pick-up. Conversely, a 5.9-year bond pricing with a 20 CPR slows to seven CPR, and extended to 8.4 years, picking up only three basis points.
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