Though prepayment fears are on the rise as rates have reached historical lows, analysts say that the steepness of the yield curve is mitigating the negative effect of fast prepays.
In a recent report, David Montano, director of mortgage research at Credit Suisse First Boston said, "The negative impact of prepayments is, to a very significant extent, offset by the shape of the curve."
The real impact of a negative prepayment environment is felt when the yield curve is flat, such as during the liquidity crisis of 1998. The current heightened refinancing activity is more similar to the 1993 refi wave when mortgages still did very well despite heavy prepayments.
Sources say that though fast prepays will always hurt investors, the current steep curve takes away some of the negative impact of prepayments by allowing mortgages to have higher dollar prices for short-duration product. Since yield and price are inversely related, low yields at the front end of the curve mean high dollar prices.
Mortgage participants, analysts said, are not as concerned about prepayments when the yield is low in the front end of the curve. Investors gain a lot in spread tightening despite the fact that fast prepays effectively shorten mortgages and make investors get their money back early. Therefore, the spread tightening offsets the negative impact of prepayments.
If the two-year yield, for instance, is 270 basis points and the 10-year yield is 450 basis points and if investors go from a ten-year to a two-year because of prepays, then they would still get 180 basis points in spread tightening.
Also, with current cheap funding, investors can still make money, allowing them to buy back more mortgages. If, for example, investors are funding at 2% and prepayments are bringing down yields from 6% to 4%, then investors can still make a 200-basis-point of spread despite being paid early.
"Indeed, the lesson is that mortgages trade well as they shorten (not widening on an OAS basis), when funding is at historic lows," said Montano.
He said, however, that investors have raised other concerns. "In this environment, we are coming across more investors concerned about extension than fast prepayments," said Montano.
Other analysts agree. Amitahb Arora, a vice president at Lehman Brothers said, "While steepness will increase prepayments by only 2%-3% CPR, the forward mortgage rates are much higher than current mortgage rates."
This suggests, Arora stated, that the market expects' much higher mortgage rates in the near future, thus implying extension risk.
Increased CMO issuance
In a related point, Montano said that increasing concern about extension combined with a steep yield curve is giving a strong boost to CMO issuance. He added that this should have a "multiplier effect on collateral demand."
CSFB is anticipating that much more than $30 billion agency CMOs will be issued for October settle, the majority of 30-year 6s and 6.5s. Gross monthly issuance in these coupons have been about $39 billion, which is expected to rise to approximately $48 billion by November/December. The report said "the current level of CMO production has the potential to significantly strengthen the rolls of 6s and 6.5s."
According to CSFB, CMO activity in 1993 was about $30 billion a month. This took up 68% of gross production. A comparable volume today would require approximately $50 billion/month in issuance. Analysts said that the CMO market is far more efficient in 2001, thus making it not likely to follow 1993 levels in CMO production.