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Extension risk quietly builds in MBS

admin | December 18, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

A shift toward higher interest rates could bring a notable slowdown in MBS prepayments after nearly nine months of steady refinancing has lowered the note rate on many conventional loans. Mortgage rates look set to increase lockstep with Treasury rates, but prepayment speeds look unlikely to just retrace their recent path. A 50 bp increase in mortgage rates could slow speeds by 10 CPR or more. That would be well below speeds when rates were last at that level in June. But pools with the right combination of loan balance and servicer could offer efficient protection.

A shift to lower mortgage note rates

Roughly 25% of loans in conventional MBS have note rates below 3.5% compared to only 5% at the start of the year (Exhibit 1). Most loans at the start of 2020 had note rates between 3.5% and 5.0% and very few had rates higher than 5.0%.

Exhibit 1: Note rate distribution of conventional 30-year MBS

Note: Distribution of note rates, not pool coupons.
Source: Fannie Mae, Freddie Mac, eMBS, Amherst Pierpont Securities

Because of this shift, the average note rate in MBS pools has fallen 37 bp since the start of the year. Most of that drop occurred after April (Exhibit 2). Originators lowered mortgage rates as note rates shifted lower, keeping their origination business operating at capacity. The share of refinanceable loans remained relatively stable throughout this time, ranging from 70% to 80% from June through December. This resulted in stable but very fast prepayment speeds.

Exhibit 2: The average MBS WAC has fallen 37 bp this year

Source: Fannie Mae, Freddie Mac, eMBS, Amherst Pierpont Securities

Mortgage originators have very little room left to lower mortgage rates, and if interest rates move higher mortgage rates are likely to do the same. Prepayment speeds should drop very quickly if this happens (Exhibit 3). For example, mortgage rates are likely to increase to 3.25% if the 10-year Treasury rate increases to 1.50%. This would leave 52% of loans at least 75 bp in-the-money to refinance, and historically loans prepay roughly 23 CPR at that level of moneyness. Mortgage rates were at this level as recently as June with 72% of loans in-the-money, and aggregate MBS prepayment speeds hit 33 CPR.

Exhibit 3: MBS prepayment speeds should fall rapidly if interest rates increase

Source: Fannie Mae, Freddie Mac, eMBS, Amherst Pierpont Securities

If interest rates reach 2.00% the survey rate should increase to 3.75% and only 28% of loans would be in-the-money and speeds would be around 13 CPR. This corresponds to levels seen in spring 2019 when mortgage rates were over 4%.

Sources of extension protection in pools, servicers and PACs

MBS investors can find some protection from slower speeds in smaller balance loans. Smaller loans typically exhibit faster turnover speeds since borrowers are more likely to want to upgrade to a larger home (Exhibit 4). They are more likely to have bought a starter home and need more space as their family, and income, grows. The graph shows only the discount portion of the S-curve, and low-loan balance loans typically have prepaid 1 CPR faster than generic loans. The trend continues to jumbo borrowers, who prepay about 1 CPR slower than generic loans. That speed difference may seem small, but it is a roughly 20% difference

Exhibit 4: Low loan balance pools provide extension protection

Source: Fannie Mae, Freddie Mac, eMBS, Amherst Pierpont Securities

There appears to be little difference in prepayment speeds across the loan balance groups, although turnover data from the 1990s and 2000s does show a difference. But an investor concerned about extension risk, but less worried about refinancing risk, can pay less for similar extension protection by buying HLB pools instead of higher pay-up LLB pools.

Investors also tend to pay less for pools from known fast servicers, and this discount often carries over to their specified pools. Fast speeds would actually be desirable in a discount environment, although it not certain that servicer behavior will have a meaningful effect on turnover speeds. Buying low loan balance pools at a lower pay-up from less favored servicers offers another avenue to boost yields in an extension scenario.

Investors can also get extension protection from PACs, although the added structure can be expensive. However, using collateral that is priced near or below par that also offers extension protection can lower the cost of the structure. One example is 20-year 1.5%s. The shorter 20-year term provides natural extension protection, and that coupon is currently priced near par.

There may also be less reason to worry about refinance risk, especially in more seasoned, high-coupon, pools. Prepayment speeds are unlikely to increase too much if interest rates fall since originators are already operating at capacity. These pools area likely to have accumulated some burnout and already so deep-in-the-money that lower rates will not entice those borrowers to refinance. Newer production, lower coupon, pools are the most exposed to refinance risk if rates fall.

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jkillian@apsec.com
john.killian@santander.us 1 (646) 776-7714

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