Expectations for slowing in prepayment speeds for agency fixed-rate IOs relative to amortizing loans offer a compelling investment opportunity, Bear Stearns analysts said in a recent report.
Within the agency universe, analysts said there is a geographic self-selection of IO loan production to areas with the heaviest concentrations of affordability lending. They found, for example, that over the past six months, 41% of 2007 agency IO loan production has come from the four states with the highest affordability lending concentrations - California, Florida, Arizona and Nevada. This is an important finding as they expect the tightening in underwriting standards to have the greatest impact on purchase demand in these areas, analysts said. In addition, they believe the data show that fixed-rate IO loans have become an important replacement for affordability products in these areas.
Since January 2006, agency fixed-rate IOs typically have paid faster than traditional amortizing loans on an age-adjusted basis. Bear Stearns analysts believe, however, that this finding is driven almost exclusively by the geographic makeup of the agency IO collateral. In fact, when they adjust for this, they found that prepayments of IO and non-IO collateral were very similar. They anticipate that the key to future prepayment behavior lies in the strength of the local housing markets and the direction of home prices in these high-affordability lending areas. They believe the tighter lending standards are likely to have the biggest impact on marginal purchase demand, particularly in California, Florida, Arizona and Nevada, where affordability concentrations are two to three times the national average. As a result, they expect prepayments of fixed-rate IO loans are poised to slow significantly relative to the amortizing universe over the next 12 months.
While IOs tend to have larger loan sizes and slightly higher gross WACs that traditionally suggest somewhat elevated speeds compared with the amortizing universe, analysts don't expect this will be the case this time around. In fact, they "strongly believe that the regional bias in IO collateral will overwhelm all other differences in loan characteristics over the next 12 months." Meanwhile, 1996 experience provides some precedents for this, analysts noted. At that time, California loan sizes were 34% larger than the universe, but the housing contraction that took place completely overwhelmed the loan size difference, slowing speeds across the entire California coupon spectrum.
This outlook implies that MBS investors have an attractive relative-value entry point available, particularly in premium passthroughs and IO backed by fixed-rate IO collateral, analysts said, in part as the market currently prices IO collateral to a faster base-case assumption versus comparable amortizing MBS.
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