Notwithstanding the considerable backup in mortgage rates the week prior, the Mortgage Bankers Association (MBA) Refinancing Index broke all-time records last week as it approached the 10,000 mark. The Index jumped 5.2% to a whopping 9387, outpacing the previous week's record-breaking showing of 8921. This should have a tremendous impact on prepayment speeds going forward, egging them on faster than ever.
"The impact on prepayments of the recent spike in the Index could be substantial," said analysts from Salomon Smith Barney last Wednesday. "A simple calculation shows that if the average MBA Refinancing Index for March ends up at 7500, then it may translate into roughly 25% to 30% increase in speeds over the next few months." Salomon added that the sharpest increase in speeds will probably be seen in the cuspy coupons.
Kevin Jackson, vice president at RBC Dain Rauscher, explained that the new high in the Index was in response to the two-week lagged 5.70% mortgage rate recorded on Feb. 28. He agreed that this level on the Refinancing Index would suggest that prepayments on cuspy coupons would surge in the coming months, adding that the Index could increase more to correspond with the 5.61% rate recorded the week ending March 14. So far, Jackson noted that new 30-year 6s prepaid at 31.2% CPR last month and new 30-year 6.5s prepaid at 52.6% CPR.
Interestingly, many analysts were expecting a lower count on last week's Index, somewhere in the range of 8700 to 8800 since rates backed up sharply the latter part of the previous week (see ASR 3/17). Though the majority of the applications were probably filed in the beginning of the week before primary markets rates went up, the unexpected surge in the Refinancing Index could also be attributed to fence sitters (borrowers who were waiting for rates to drop further) locking in rates before they rise significantly - which is typical borrower behavior in rate backups.
This week, analysts are expecting a much lower reading on the Refinancing Index as primary rates have increased by 18 basis points to 5.91%, said JPMorgan Securities analysts last Wednesday (see MBS recap for details).
The recent selloff is also expected to mitigate speeds in the upcoming prepayment reports. UBS Warburg said that the backup in rates would most likely temper speeds in the June report - specifically 5.5s on the cusp of refinanceability.
Last fall's prepayments pale in comparison
Prepayment speeds going forward are expected to be faster for a given relative coupon compared to how they were in the fall, said analysts from Merrill Lynch in a report released last Wednesday.
In the study, Merrill compared the composition of the market today with the market last fall. As a point comparison, Merrill used prevailing rates, also used in a similar analysis conducted roughly six months ago. Analysts found that the relative structure of the mortgage market is similar to last fall, meaning that the number of refinanceable mortgages appears to be roughly the same now as it was then.
However, currently, there are more loans that are deeply in the money. This would, to some extent, explain the higher number of applications seen today.
Merrill expects an increase of about 5% CPR for each weighted average coupon (WAC) bucket. This is enough to raise total prepayments to a level roughly 25% higher then the level experienced last fall. Merrill noted that this 5% CPR increase is after adjusting for relative coupon. So speeds will clearly increase more on absolute terms, specifically in lower coupons, said analysts.
What are investors to do?
Despite the recent backup in rates, and even if rates inch up higher from current levels, the market is still expecting a flood of prepayments for the next two months at least, as the surge of applications work themselves through the mortgage bankers' pipelines.
To combat fast prepayments, many investors have taken to buying low coupon production: 15 year 4.5s or 30-year 5s. However, some investors argue it is too risky to move too far down in coupon. If there is a reversal in rates from here - low coupons could rapidly become illiquid. Moving into newer production loans that have been refinanced, or pools that might be a little less responsive to potential refinance incentives, may be wiser, they say.
Steve Point, a fixed-income portfolio manager at Glenmede Trust Co. currently likes 15-year 5s or 30-year 6s. He prefers pools with more recent origination.
"We are not making a judgment as to whether the market is going to rally or sell off necessarily," said Point last Wednesday. "We like the generally defensive nature of mortgages and we are just trying to work to mitigate the negative consequences of immediate rapid paydowns."
He said that going into the down-in-coupon trade may not be the right strategy, but suggested moving into some of the premium priced mortgages.
"You can take pretty much any of the higher coupons and roll them at extremely fast prepayment speeds and still have pretty decent yield," said Point. "I think capturing negative paydown returns in a lot of coupons is going to offset the negative consequence of duration extension. Don't buy mortgages and expect to maintain your duration. Buy mortgages for what they do give you - pretty nice yield and a good defensive posture when rates do turn around."
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