After the refinancing boom that characterized 2003 prepayments, turnover should be the story in 2004.

"As long as the economic recovery remains on track, mortgage rates will remain elevated and refinancings will become less of an issue," said Steven Bergantino, a senior vice president in mortgage research at Lehman Brothers. "We expect that in the year ahead - with a flat to rising rate environment - investors will begin to focus more and more on housing turnover."

In a recent article, Bergantino bases his assumptions on the fact that the most recent originations are in the 5.5% or lower coupon buckets.

Bergantino said that looking at the past serves as a source of guidance for discount prepayments in 2004 and early 2005. What becomes apparent, he says, is that the expected backup in 2004 should look more like the one that occurred from 1994 to1995 than the backup from 1999 to 2000.

In the report, Bergantino stated that prepayments during the mid-1990s' backup were about 4% CPR lower compared to 1999 to 2000. Two factors probably caused the slower speeds in the mid-1990s: differences in economic conditions and differences in borrower behavior.

Over 1999 to 2000, the country had a strong economy and the housing and stock markets were booming. In comparison, GDP and stock market growth, as well as house price appreciation, were less significant in 1994. This depressed prepayments in the mid-1990s versus those over the 1999 to 2000 backup. Going forward, even though it seems like an economic recovery is forthcoming, many economic forecasts seem to suggest that housing price appreciation could be muted or flat, resulting in slower turnover rates.

Differences in borrower composition in 30-year collateral also affected speeds in these different time periods. The mortgages prepaying in 1999 to 2000 were originated in 1997 to 1998 and early 1999, when the yield curve was relatively flat. In contrast, in 1992 to 1993, the yield-curve environment was steeper. Thus, those who took out mortgages in the mid-1990s in a steep yield-curve environment were more likely longer-horizon borrowers than those in 1998 to 1999.

Given the steep yield-curve environment of the past two years and the likelihood of a weak housing market going forward, the turnover behavior of recently originated 30-year collateral should more closely mimic the mid-1990s experience.

Based on past experience, a strong economic recovery and steep yield-curve environment could help push prepayments on 2003 vintages. However, a weakening housing market could offset these factors. Aside from this, by moving into a 30-year mortgage in a steep yield-curve environment, this implies that the borrower intends to stay put, and is relatively insensitive to attractive hybrid opportunities.

The one potential mitigating factor is that unlike in either of the past backup episodes, the yield curve continues to remain steep. "There is really no hard data on backups that occur in steep yield-curve environments," said Bergantino. Borrowers with below market 30-year mortgage rates who are inclined to move could take out, say, a 5/1 hybrid in order to keep their monthly payments from increasing (at least in the short run).

However, the fact that most of these borrowers took out 30-year mortgages when the yield curve was already steep suggests that they are less responsive to differences between fixed and hybrid rates than the average borrower.

Even in the event of a strong economic recovery and a continued steep yield-curve environment, the firm expects discount prepayments in 2004 to be 2% to 3% CPR slower compared to the last backup in mortgage rates.

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