With current mortgage rates in the 5.90% level, Street analysts predict the market is now close to another refinancing explosion.
Mortgage rates are so low in part, because the basis tightened quite dramatically in the beginning of the year. With mortgage rates inside of 6.0%, analysts from Bear Stearns said that well over 80% of the mortgage universe is still refinanceable. Further, over 70% of 2002 production would have another opportunity to refinance at these levels. This means that prepayments will be strong into the second quarter of 2003.
"The MBS market is closer than it thinks to the next leg of the refinancing wave," said Dale Westhoff, senior managing director at Bear. "The next major rate threshold is a 5.60% to 5.70% mortgage rate (3.45% 10-year). This would push mortgage origination volumes above 2002 levels."
Other analysts agree that a move downward to the 5.60% to 5.70% level will definitely expose a whole lot of the loans in the 6.0% population - which have the 6.40 to 6.75 gross WAC - to being very fully refinanceable. They said that if rates get back to the 5.60% level, refinancings will go up again and 6s will paydown the way 6.5s are currently paying.
Citing the fact that the seasonally adjusted refinancing index rose by 8% last week, analysts from JPMorgan believe there is "still no hint of a slowdown in refinancing activity."
Last week was the third in a row for an above 5,000 reading on the Mortgage Bankers Association (MBA) Refinancing Index, which is actually equivalent to an over 6000 refinancing index. This is based on the currently smaller refinanceable universe relative to October, JPMorgan analysts said. As such, prepayment speeds are likely to pickup in March, after a marginal slowdown in February. They do not anticipate any major slowdown for the first half of the year.
Coupon compression
Analysts from Bear noted that mitigation of extension risk in a compressed vintage environment and compressed coupon MBS market will continue to be a theme this year.
They believe that the 6.5% coupon currently dominates the market but this would change by the first half of the year. By then, both the 5.5% coupon as well as the 6.0% coupon will probably comprise over 60% of the entire mortgage universe. This coupon compression would have implications on the MBS market because of the eventual likelihood of a sell-off.
"The traditional response in a sell-off is to move up in coupon," Westhoff said. "Though there are still 6.5s and some 7s out there, there is a fairly limited universe of higher coupons to select from."
He added that the 5.50% coupon is in the most vulnerable position because there will be a concentration of extension fears in that particular coupon, as it is expected to comprise about 25% of the mortgage universe by mid-year.
With this in mind, Westhoff said that there are ways to combat extension risk aside from moving up in coupon at this point. One of them is moving into 15-year collateral.
"There is an obvious yield give but there is also a big pickup in convexity both on the call side as well as on the extension side, which makes this a very appealing product." He also suggests reducing extension risk through hybrids, which are shorter duration mortgage assets, or moving into more seasoned securities.
He explained that though seasoned pools are paying very fast now, once rates move higher, and refinancing subsides, seasoned pools would exhibit much stronger turnover than the brand new pools. This is because these borrowers have a lot more equity in their property, supporting additional cash-out and trade-up activity and so speeds on these mortgages would not be slowing as much as the brand-new pools, particularly brand-new 5.5s.
Westhoff said that though investors should focus on extension risk, in the near term the carry trade should still outweigh other considerations.
"It's a timing issue, " he said, adding that in the first quarter of 2003, the carry trade will dominate, which is a continuation of what happened in 2002. However, the question becomes "When are rates likely to move higher?", something predicted for the second half of the year. He suggests taking a "relatively defensive stance at this point, adding opportunistically with 15-year product and other shorter duration mortgage assets in preparation for the eventual sell-off, which remains contingent on various factors."
