While prepayment penalties definitely dampen prepayments on jumbo mortgages during refinancing waves, this effect does not appear to be fully priced into jumbo collateral, according to Salomon Smith Barney Inc. Penalty jumbos, increasingly popular, now account for $500 million per month in issuance, eclipsing agency penalty issuance.

When the mortgage markets are free from major refinancing waves, prepayments are about the same for jumbos with or without prepayment penalties. But this equality changes dramatically when the Treasury markets rally and mortgage rates fall.

"In a 100-basis-point rally, which is not that unlikely...the prepayment projection is 55% faster on the pass-through without the prepayment penalty," said Dave Stinner, a vice president at Salomon SB. This difference in prepayments "translates into a principal balance that is 8% lower for the mortgage product without the prepayment penalty." (This projection is based on generic fixed-rate jumbo collateral with a 6.50% coupon rate, 7.10% gross weighted-average coupon and a 29.8-year weighted-average maturity.)

Stinner translated the prepayment advantage into pricing. He said current pricing for jumbo whole loans with prepayment penalties "is in the low-twenty 32nds behind Fannie Maes. Using an equal dollar price for a new-issue whole-loan pass-through, with or without prepayment penalty, places a value of eight basis points OAS [option-adjusted spread] on the prepayment penalty."

The market for jumbos with prepay penalties is younger even than that for agency mortgages and only a couple of years old, but penalty jumbos are rising more rapidly, especially on a proportional basis.

Jumbo issuance averages $500 million a month, outstripping agency issuance of $300 million to $400 million a month, Salomon SB said.

In April, $510 million in jumbo prepayment-penalty product was issued. First Nationwide Mortgage Corp. dominated with $330 million in issuance, while two new entrants, Countrywide Home Loans Inc. and GMAC-RFC, each issued $50 million.

Salomon SB estimates that $5 billion in jumbo mortgage-backed securities with prepayment penalties are outstanding.

The prepayment penalty is generally levied for five years after origination and costs the borrower six months of interest. This combination parallels the most popular penalty used in the agency market. - ES

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