Even with the recent positive home price acceleration data from the Office of Federal Housing Enterprise Oversight, the rise of fixed mortgage rates has fueled discussion on the Street about a slowing housing market and its effect on MBS prepayments.
In a recent report, JPMorgan Securities analysts said that 30-year and 15-year prepayments have converged slightly, a trend that could continue in a softer housing market. When the housing sector was less heated, prepayment rates on 15-year discounts were typically similar to or even faster than those on their 30-year counterparts.
Paul Jacob, a mortgage strategist from Countrywide Securities, spoke in terms of slower home price appreciation and slower housing turnover. "Slower turnover - i.e., fewer sales each year - means modestly slower baseline prepayments overall," he said. The interesting question, Jacob added, is if slower home price appreciation would affect 30-year product differently from 15-year collateral. Over the last 1.5-to-two years, 30-year prepayment speeds have been somewhat faster compared to 15-years. Jacob believes that 30-year prepayments would slow somewhat more than 15-year equivalents, although the extent of potential convergence would depend on where interest rates are heading. "If rates are rising substantially while housing is slowing, then 30-years would likely slow a lot, and converge with 15s," he said. However, if rates remain around current levels, a considerable amount of 30-year borrowers could still do "affordability" refinancings such as moving into interest-only and negative amortization loans. Under this scenario, 30-year speeds would remain noticeably faster than 15-years, Jacob said.
In Bear Stearns' September edition of Short-Term Prepayment Estimates, analysts focused on the problem of extension risk. Discount MBS prepayment rates are currently running at 50% above historical levels and nearly 100% faster in California, so "even if the housing market reverts to a more normal home price growth pattern of 1% above the inflation rate, it implies a significant lengthening of MBS portfolio durations," Bear analysts wrote. They predict that a reversion in home price growth to 1999/2000 levels would slow discount prepayments from today's 13 CPR level to about 9 CPR. Analysts also noted that today's extension scenario would be very different from 2003 when sharp increases in rates stopped rate/term refinancings - instantaneously removing concentrated blocks of mortgages from the refi window. This translated into relatively small rate changes, causing dramatic shifts in mortgage durations. By contrast, with most of the mortgage universe currently outside the fixed and refinancing windows, extension risk today is much more reliant on housing sector performance and on the borrowers' ability to cash out their equity, which depends on rising home prices and the existence of attractive cash-out refi options.
Aside from extension risk, Lehman Brothers, in a related report, highlighted the repricing and credit risks from a slowdown in prepayments - driven by decreased housing turnover rates. The impact of the decelerated prepay speeds, analysts warned, would be felt more in the agency market. Risks to credit performance, on the other hand, would be limited to the subprime sector.
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