By the Numbers
Playing early prepayment trends in second lien RMBS
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.
The combined effect of falling interest rates and tighter spreads has pushed prices above par on much of the universe of bonds backed by closed-end second liens. The premium prices have increased focus on prepayment risk, especially given existing issuer call risk on the bonds. Investors expecting fast speeds can take advantage through mezzanine classes, and investors expecting slow speeds can concentrate on premium or IO-like profiles.
Split expectations on prepayment speeds
Investor opinions on prepayment speeds across closed end second liens remain split and those divergent opinions will likely drive investors to different parts of the capital structure in second lien securitizations. Those in the camp of slower speeds can express their view in premium senior cash flows and IO-like profiles. Those forecasting faster speeds may look to mezzanine bonds that will generate total return from rolling down the spread curve as the sequential structure de-levers or discounted subordinate cash flows to express a view on faster speeds.
There is a stark lack of consensus amongst investors around future prepayment speeds in newly originated second liens. The case for slower speeds is bolstered by lower average loan sizes, substantially-out-of-the-money strikes on blended first and second lien note rates, and friction to refinancing associated with elevated origination costs relative to smaller loan balances. Those in the camp of faster prepayments will point to the possibility of second-to-second lien refinancing, especially in the face of strong home price appreciation where refinancing incentive may be present even absent a drop in mortgage rates and borrowers’ ability to roll origination points and fees into a new loan to reduce friction to refinancing.
Early trends in speeds
As the universe of securitizations backed by closed-end second liens continues to season and ramp there are some early trends emerging in the prepayment profile of these deals.
- Prepayment S-curves have been relatively flat to date
- Home price appreciation should lift speeds, especially as steep risk-based pricing grids create refinancing incentives for loans with higher CLTV and lower FICO that see substantial HPA
- Loan size matters, and smaller balance loans have exhibited substantially slower speeds
To date, speeds have been relatively benign and are generally falling in-line with pricing conventions. Prepayment S-curves on loans securitized in recent vintage CES deals have been relatively flat and mirror those of conventional loan balance collateral, albeit with somewhat elevated at-the-money speeds relative to conventional loan balance stories. (Exhibit 1) The obvious caveat here is the absence of deep in-the-money observations, particularly where a drop in rates would create incentive to fully refinance the existing first and second lien balances.
Exhibit 1: CES S-curves mirror conventional loan balance loans
Source: Santander US Capital Markets, CoreLgic LP, Intex, eMBS, Fannie Mae, Freddie Mac
While S-curves are relatively flat, absolute speeds differ, particularly when cutting the universe by mark-to-market CLTV where lower CLTV loans are prepaying substantially faster than higher CLTV loans given the same amount of incentive (Exhibit 2).
Exhibit 2: Mark-to-market CLTVs drive CES prepayments
Source: Santander US Capital Markets, CoreLogicLP, Intex
One plausible explanation for faster speeds across lower mark-to-market CTLV loans may be substantial refinancing incentive associated with HPA related deleveraging. While all originators will maintain their own proprietary risk-based pricing grids, loan level pricing adjustments may be anywhere from one to three points difference in risk-based based pricing adjustments between higher CLTV loans and lower CLTV ones. Assuming a roughly 3-year duration on the loan cash-flow LTV related refinancing incentive could range from roughly 3/8ths of a point to one point depending on borrowers’ credit scores.
This phenomenon is particularly pronounced when comparing at-the-money speeds on loans with embedded HPA versus those without. Comparing loans with similar seasoning, in this instance 6-12 WALA, shows that non-SATO adjusted prepayment speeds on loans with 10% of mark-to-market HPA were substantially faster than comparably seasoned loans with no home price appreciation (Exhibit 3).
Exhibit 3: CES loans with HPA prepay faster at-the-money
Source: Santander US Capital Markets, CoreLogic LP, Intex
In addition to HPA, loan size should drive faster prepayments in closed-end second liens as refinancing friction associated with origination costs are less impactful on higher balance loans and less of a deterrent to refinancing. Estimates of origination costs inclusive of appraisals or AVMs, processing fees, margin and other closing costs imply that these costs could be upwards of 300 bp on a second lien with a balance of $100,000, slightly larger than the average size of loans securitized in recent vintage CES transactions.
Assuming a $100,000 loan and just over three points in origination costs, at 50 bp of incentive, the breakeven to recoup those origination costs to the borrower would be just over eight years, creating substantial disincentive for the borrower to refinance the loan. Conversely, if the loan size is $300,000 and the borrower has 150 bp of incentive, the borrower would recoup those costs in 1.5 years (Exhibit 4). One key assumption underpinning the friction to refinancing is the borrower does not roll these costs into the balance of a newly refinanced loan thereby reducing the out-of-pocket expense associated with the refinancing.
Exhibit 4: Origination costs, lower balances add friction to refinancing CES
Source: Santander US Capital Markets
The ultimate friction to refinancing in second liens, or conversely the greatest source of prepayment risk, is borrower incentive to consolidate the loans into a single cash-out refinancing. However this option is currently substantially out-of-the-money for borrowers with newly originated second lien mortgages. Assuming a 10% second lien note rate, a 3.5% first lien note rate, a 50 LTV first lien and a 20-point thick second lien, the weighted average mortgage rate is approximately 5.375% or roughly 1.75% out-of-the-money versus current par mortgage rates or 2.25% assuming 50 bp of incentive to consolidate into the cash-out refinance loan. While prepayment S-curves may remain relatively flat when these loans are modestly in-the-money they will likely steepen appreciably deeper in the money. Investors with levered exposures to deep in-the-money speeds may look to hedge with receiver swaptions to protect against steep in-the-money prepayment S-curves.
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