Prepayment responsiveness has been significantly reduced because of the housing/financial crisis that has resulted in very tight credit conditions and significant home value declines. Analysts expect this phenomenon to remain for some years, especially as home values continue to weaken and underwriting standards tighten.

Slower prepayments are positive for agency MBS given that most of the market is trading at a premium. The sector should also benefit from limited supply and better convexity.

Despite the good news on the prepayment side, there is still no good news in terms of home valuations. Year-over-year home price declines reported among the latest Standard & Poor's/Case-Shiller Home Price Indices, Federal Housing Finance Agency (FHFA) House Price Index, and existing and new home sales ranged from over 3% to nearly 6%.

In the Case-Shiller release for February, housing values on the 20-City Composite were on the edge of a double-dip, and 10 MSAs set new price lows.

"There is very little, if any, good news about housing. Prices continue to weaken, trends in sales and construction are disappointing," said David Blitzer, chairman of the index committee at S&P. "Fourteen MSAs and both Composites have continued to decline month-over-month for more than six consecutive months as of February."

Bank of America Merrill Lynch analysts noted that the increased winter share of distressed properties has partly contributed to the recent home price weakness and that it should wane in the coming months. They believe home prices are in the process of bottoming out with an expectation of a national 3% decline for 2011. Meanwhile, Wells Fargo analysts expect home prices might decline between 3% and 5% annually over the next three years, and Deutsche Bank Securities analysts predict prices nationally should slide another 4% to 5% this year, and a bit more in 2012 before finding a bottom in mid-2013.

Distressed housing inventory remains a drag on home prices and while 1Q11 foreclosure filings were down significantly from 4Q10 and 1Q10 and were at a three-year low, the decline is attributed to the "robo-signing" and other issues related to documentation.

RealtyTrac CEO James Saccacio anticipates that foreclosure activity will pick up as lenders and servicers work through the backlog caused by the documentation issues. The RealtyTrac monthly foreclosure report stated that judicial foreclosure states, such as Florida and Massachusetts, "accounted for some of the biggest quarterly and annual decreases in the first quarter." Given the pace of sales, three years or more is generally cited as the time it will take to remove the current housing overhang.


Credit Keeps Tightening

Tight credit conditions are also inhibiting the recovery of the housing market. National Association of Realtors chief economist Lawrence Yun previously stated that, while home sales are on a recovery path, it will be uneven and "not every month will show a gain," a factor he attributed largely to tight credit conditions.

National Association of Home Builders Chairman Bob Nielsen has also noted that "many consumers remain skittish about the health of the housing market and overall economy, particularly in view of recent legislative and regulatory proposals that could make it much harder to get a mortgage."

Already tight credit standards continue to tighten, contributing to the housing markets' slow recovery. Earlier in April the Federal Reserve requested public comment on a proposed rule under Reg Z (Truth in Lending Act) that would require creditors to determine a consumer's ability to repay a mortgage before making the loan and would establish minimum mortgage underwriting standards.

The Fed is accepting comments until July 22 with the rule set to be finalized by the new Consumer Financial Protection Bureau. BNP Paribas said the proposed rule should be a positive for MBS in the intermediate and longer-term because of the lower supply and reduced negative convexity.

New rules on loan originator compensation went into effect at the beginning of April and will contribute as well to slower prepayment speeds. Under the new compensation rules, loan originator compensation based on a mortgage transaction's terms and conditions is prohibited - except in the case of loan size; loan originators are prohibited from steering consumers to a loan that provides the broker with better compensation - unless it's in the consumer's interest; and payments by any person to the originator are prohibited in case the originator has received compensation directly from a consumer in the transaction.

The impact is positive for MBS, Morgan Stanley analysts said, as the results will be slower prepayment speeds and an improvement in the convexity profile of conventional mortgages. They believe 4.5% and 5% coupons will benefit the most from the expected slowing in speeds. In addition to the benefit to the belly coupons, their analysis showed that the new compensation rules will be negative for GNMA/FNMA swaps as conventionals benefit from slowing prepayments and improving convexity. It is also negative for specified pool pay-ups, they said, as the convexity of TBAs improves.

In late March, the banking regulators issued a proposed rule on credit-risk retention and qualified residential mortgages (QRMs) as required under Section 941 of the Dodd-Frank Act. In addition to other requirements such as debt-to-income and delinquency limits, the proposal would require a 20% down payment in order to be considered a qualified residential mortgage (QRM) in which the seller would not have to retain some risk.

Loans guaranteed by the GSEs, however, would be exempt although a bill has been introduced that would remove this exemption. Comments will be accepted until June 10.

While loans guaranteed by the GSEs would be granted a risk retention waiver, the market still expects some ramifications. "The QRM end game is higher rates," Citigroup Global Markets analysts said. Lenders are likely to pass on the incremental capital cost to borrowers they pointed out, and "to prevent taking full market share of the non-QRM sector of the market as these rates increase due to risk-retention, Fannie [Mae] and Freddie [Mac] will likely have to increase their risk-based pricing on these loans." The result of this for the existing agency MBS market should be lower prepayment speeds and lower refinancing volumes, analysts said.

Morgan Stanley warned that adoption of the QRM requirement will likely cause mortgage credit availability to shrink, causing a near-term adverse impact on housing.

A House Financial Services Subcommittee recently approved eight bills on GSE reform and the bills are now before the full House Financial Services Committee for review.

One of the proposals is the GSE Subsidy Elimination Act, which would require FHFA to gradually increase the guarantee fees over the next two years. The other is the GSE Credit Risk Equitable Treatment Act, which would require the GSEs to be held to the same standards as other secondary mortgage market participants in terms of risk retention under Dodd-Frank. If passed, it would lead to higher borrowing costs.

GNMAs have not been exempt either. Tightening in Federal Housing Administration (FHA) underwriting through higher mortgage insurance premiums and a new definition of "net tangible benefit" to streamline refinance reduces the incentive and is expected to further reduce voluntary prepays. The change became effective on April 18.

Royal Bank of Scotland MBS analysts said they expect the influence of the tighter credit to start in the May and June GNMA prepayment reports with higher coupons seeing the most slowing. In addition, another increase in FHA fees is likely in the next budget.


Time and Jobs the Cure

Credit Suisse analysts have said that the only cure for the housing sector to return to more normal levels is time, as that will allow a sizeable number of foreclosed properties to be absorbed, home values to start to recover, and credit standards to ease.

Deutsche economists said the trend in home prices going forward depends on two factors: housing demand and bank lending practices. Continued improvement in the jobs market should increase demand for housing, they said especially as the affordability index is at an all-time high. They would expect banks to start easing lending standards for residential mortgages if a strengthening economy allows them to write off fewer nonperforming loans and take lower charge-offs. Bank easing does not appear on the foreseeable horizon, however, given that these institutions are dealing with Basel III capital rules, changes required under Dodd-Frank, and other regulatory capital requirements.

Regarding the outlook for the unemployment report, 2011 has been projected to remain relatively high with the Fed predicting 8.4% to 8.9%, but declining to 7.6% to 7.9% in 2012 and to 6.8% to 7.2% by 2013. This all points to a several-year process for recovery in housing, and thus benign prepayment speeds despite historically attractive mortgage rates.

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