By the Numbers
Drivers off out-of-the-money speeds in prime 2.0
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. This material does not constitute research.
Some investors in prime 2.0 RMBS have shifted their focus from call protection to extension protection as prepayment rates appear poised to slow down. Investors can insulate themselves from extension risk to some extent through collateral selection as certain loan attributes have historically shown faster out-of-the-money speeds than others. Home price appreciation and borrower deleveraging appears to be the most prominent potential drivers of out-of-the-money speeds. Origination channel and loan size also will likely influence speeds as well.
The combination of higher interest rates coupled with the recent spate of prime issuance backed by out-of-the money collateral has shifted investors’ focus from call risk to extension risk. In all likelihood, investors will continue to see issuance backed by out-of-the money loans as the confluence of increasing supply coupled with limited new issue diligence capacity has increased the timeline to bring deals to market.
Given this, investors in the sector can attempt to screen for collateral attributes that should help mitigate extension risk. There are certain collateral characteristics that have historically offered extension protection, particularly seasoned and adjustable-rate loans. Elevated prepayment rates have substantially decreased the float of seasoned prime bonds, and private-label ARM issuance is somewhat negligible as a result of banks retaining shorter-duration ARMs in their held-for-investment portfolios. Given the inability to gain meaningful exposure to these profiles in private-label space, investors should focus on attributes of fixed rate loans that may prove to offer faster speeds out-of-the-money.
The historical performance of fixed-rate loans backing prime private-label trusts suggests that continued robust home price appreciation will likely be the primary driver of faster speeds on out-of-the money loans. Lower LTV loans and cash-out refinances have exhibited substantially faster speeds against the backdrop of higher interest rates than many other collateral attributes. While a steep forward curve suggests interest rates are likely to continue to rise, home prices appear poised to continue to rise along with them. Based on Case Shiller projections, home prices in high-cost states such as New York, California and Connecticut are projected to increase between 8.8% and 16.8% over the next two years. If historical precedent holds, continued rising home prices should help provide a tailwind to faster out-of- the money speeds. Controlling for any risk-based pricing or SATO on loans in PLS trusts, but not any other factors that may influence prepayment rates, cash out refinances have on average paid roughly 17 CRR when 50 bp out-of-the-money while rate finances have prepaid roughly 8 CRR slower given the same amount of incentive. Out-of-the-money speeds were faster on jumbo conforming rate refinances than those observed in non-conforming loans. And while there are a limited amount of observations on purchase loans with 50 bp of negative incentive, prepayment rates were near zero for that cohort.
Looking at out-of-the money speeds based on loans’ original loan to value ratios shows that loans with original LTVs between 70 and 80 have exhibited the fastest out-of-the-money speeds. One obvious caveat here is that seasoning along a historically strong home price environment likely drove faster out-of-the-money speeds on these loans as elevated prepayments were observed on seasoned loans within the cohort where substantial equity growth likely fueled cash out refinances. However, it should be noted that the overwhelming majority of out-of-the-money observations will be on seasoned collateral given the recent protracted low interest rate environment. Loans with original LTVs of 70 to 80 have prepaid at roughly 25 CRR given 50 bp of negative incentive while prepayment rates across other LTV buckets have been fairly negligible. While near-term prepayment rates may not be primarily driven by LTV, continued home price growth should provide a longer term positive tailwind for prepayment speeds on lower WAC collateral
And while home prices and borrower deleveraging look to be the primary drivers of out-of-the money speeds some other attributes appear poised to drive faster speeds on loans with negative incentive going forward as well. One factor that may drive faster out-of-the-money speeds is the channel through which a loan is originated, Loans originated through retail origination channels in private label securitizations have historically exhibited a flatter S-curve than those originated through wholesale or TPO channels. Given 50 bp of negative incentive, loans originated through retail channels have prepaid at roughly 10 CRR while those originated through broker or TPO channels have prepaid at nearly zero. One possible explanation for this phenomenon is that as loans fall out of the money and refinancing volumes decrease, broker and wholesale channels may be more focused on originating higher margin products like expended credit or non-QM loans against the backdrop of tighter primary secondary mortgage spreads, decreasing gain-on-sale margins and lower volumes in higher credit quality borrowers.
Looking across other attributes such as loan size shows that given 50 bp of negative incentive conforming jumbo loans prepay substantially faster than non-conforming ones. Jumbo conforming loans with 50 bp of negative incentive have prepaid at roughly 22 CRR historically while non-conforming loans have prepaid at roughly 8 CRR. Given deleveraging and home price appreciation look to be the primary drivers of out-of-the-money speeds, controlling for original LTV ratios across the two cohorts shows an even more magnified difference as jumbo conforming loans with original LTVs of 70-80 have prepaid north of 25CRR while non-conforming loans with comparable original LTVs have exhibited fairly nominal prepayments.
While investor concerns over extension risk in deals backed by out-of-the money collateral appear to be well founded, there do appear to be some mitgants to that risk. Strong continued home price growth should keep out-of-the-money speeds elevated, potentially more so on loans with jumbo conforming balances originated through retail channels.
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