MBS prepayments begin to slow
By Jim Reber
It was only about 120 short days ago that interest rates were hitting their cyclical lows. This time through, we can add the adjective “generational” to the above statement. The long and winding road downward for all rates was paved by a number of participants. The cast certainly included Ben Bernanke and the Federal Reserve, but in reality they were just reacting to fact and inference they had gathered about the strength, or lack thereof, of the global economy.
It’s not altogether clear where rates are headed. For most of the last two years, the interest rate curve has been predicting a substantial rise in rates. Eventually today’s investors will be proven right, but they’ve been wrong for about three years now. In the meantime, as rates have been quite low since 2008, prepayments on mortgage loans have been a topic of great debate among lenders, borrowers and mortgage-backed securities (MBS) investors. Still, as rates have risen since November 2010, it’s time to look at the MBS market’s reaction.
Prepayment Variables
Rational borrowers will prepay their debt and will refinance it when they can cut their costs. You and I do it, corporations do it, and certainly governments do it. The MBS market, which is larger than even the Treasury’s, is now old and deep enough for analysts to track prepayment histories. These records make their way into prices that investors pay for the resulting securities.
In the past it was assumed that if a borrower could save about 75 basis points on his or her loan, and expected to be in the house for about four more years, then the borrower would prepay the loan and take out a new, cheaper one. Interest rates fell in 1995, ’98 and 2003, and each time mortgage securities showed a rash of prepayments, which makes complete sense. This time, even though mortgage rates are lower than at any period in 50 years, prepayments are much tamer.
The culprit is property values. Housing prices peaked in 2006, and most metro areas are about 30 percent below their high water marks. So, unless a homeowner can pony up almost half of the cost of the house as a down payment, these record low rates are simply an irritant.
Recent Results
Let’s use a very common financing vehicle as an example: a conforming 30-year fixed rate loan. The entire population of those loans with a borrower’s rate of about 6.5 percent has prepaid over the last year at an annual rate of about 32 percent. In the last 120 days that speed has slowed down by about one-fifth. However, if roughly one in three of a group of loans prepaying in a year sounds fast, consider the 2003 experience.
That year, that same pool of loans averaged prepayment speeds of over 52 percent. And, please note that in 2003 the average posted rate for conforming loans was 5.83; in 2010, the average rate was more than a full percentage point lower, at 4.69. This is proof of the dearth of equity that has persisted since 2007. This also suggests than any additional creep-up in mortgage interest rates from here would further shut down the refinance machine.
How to Take Advantage
For investors in MBS who are exposed to, or are worried by, rising rates, there are essentially three strategies that can be followed to minimize the exposure. None are cure-alls, but are easily accomplished, and are used by hundreds of community banks.
First, a bank can purchase floating rate securities. The current availability of ARMs is such that the vast majority is of the “hybrid” variety, which means they will have a fixed rate period of from three to ten years before becoming true ARMs. Most will also have noticeable premium prices as well. They also may have paltry yields for a few years.
Next, there are plenty of short stated final securities around. Fifteen- and ten-year MBS pools are available, as are short maturity CMO tranches. Many of these will have average lives of well under five years.
And then there’s the premium pool story. One of our recent recommendations is a 15-year 4.5 percent pool issued by either Fannie Mae or Freddie Mac. The price on it has recently been around 105, so a buyer will need to be aware of that. However, the prepayments have recently slowed by about one-third, and if rates rise even another 50 basis points, we can anticipate more slowing. This will cause the yield to improve as the premium has more time to be amortized.
* * * * *
ICBA Securities can consult with you regarding an ideal mix of mortgage-related securities for your institution. Also available is a comprehensive financial analysis, the Performance Profile. Contact your ICBA Securities sales rep or visit www.icbasecurities.com for more information.
Jim Reber is president/CEO of ICBA Securities and can be reached at 800-422-6442 or jreber@icbasecurities.com.
fbabancserv.wordpress.com 
