By the Numbers
Home price appreciation drives faster second lien MBS speeds
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.
Second liens securitized in private-label MBS continue to pay fast. While several factors appear to be driving the faster-than-projected speeds, home price appreciation and spread at origination, or SATO, appear to be the biggest. The good news? Prepayments, while fast, have been consistent both in- and out-of-the-money and may slow lockstep with decelerating home price growth.
Sizing up second lien speeds
Prepayment speeds across securitized, fixed-rate second liens, while elevated, remain fairly consistent given changes in borrowers’ refinancing incentive. That suggests the asset class still offers reasonably attractive convexity, particularly when compared to other private-label exposures like jumbo and non-QM, which exhibit steeper S-curves (Exhibit 1).
Exhibit 1: Second liens collateral offers better convexity than non-QM and prime jumbo
Source: Santander US Capital Markets, CoreLogic LP
The most meaningful driver of elevated speeds across second liens looks to be home price appreciation. Lofty levels of HPA can drive a borrower to refinance for a couple of reasons. Substantial enough levels of HPA could create incentive for a borrower to refinance a second lien to take more equity out. It could also have the impact of materially reducing LLPAs on a second lien, shifting the refinancing elbow even absent a drop in primary and associated second lien mortgage rates (Exhibit 2).
Exhibit 2: Low CLTV second liens prepay fast both at- and in-the-money
Source: Santander US Capital Markets, CoreLogic LP
Stratifying second lien S-curves by mark-to-market CLTV shows that loans with substantial HPA prepay fast even absent any rate refinancing incentive, and even in cases where the borrower has negative rate incentive. Second liens with CLTVs of 40 or less have prepaid 27 CPR when they have no incentive, only 2 CPR slower than when those borrowers have 100 bp or more of rate incentive. A survey of originators’ rate sheets suggests that borrower deleveraging could create as much as 200 bp of incentive when their combined LTVs fall below 60.
Further evidence that home price appreciation may be the single biggest driver of fast speeds can be seen when looking at the population of second liens that have prepaid compared to loans still sitting in MBS trusts. Lower-rate loans that have prepaid out of second lien trusts have experienced substantially more home price appreciation than comparable loans that have not (Exhibit 3). This is particularly evident in loans with note rates ranging from 8.0%-9.0% which should have little to no pure rate refinancing incentive. Prepaid loans with note rates between 8.0% and 9.0%, on average, exhibited a roughly 10-pont decline in CLTV between origination and prepayment while those that have not prepaid have exhibited substantially less deleveraging (Exhibit 3).
Exhibit 3: Home price appreciation, deleveraging fueling faster second lien speeds
Source: Santander US Capital Markets, CoreLogic LP
If HPA matters, then geography does too
If HPA is in fact one of the largest influences over second lien prepayments, then geography matters. Investors seeking call protection and better overall convexity should look for pools with larger concentrations of loans in MSAs and states with weaker prospects for home price appreciation. When cutting the universe of fixed rate second liens by geography, states like California and New Jersey that have exhibited both consistent and elevated levels of home price appreciation prepay significantly faster than states like Florida and Texas given the same amount of refinancing incentive (Exhibit 4). Admittedly, investors must balance the desire for better convexity associated with weaker home price appreciation with any credit concerns associated with potential home price depreciation driven defaults, particularly on second liens where substantial HPD will not only drive higher defaults but correlated elevated loss severities.
Exhibit 4: States with more HPA prepay faster
Source: Santander US Capital Markets, CoreLogic LP
Thoughts on other drivers of prepayments
While HPA looks to be the primary driver of elevated prepayments, this phenomenon is localized to more seasoned loans that have had the opportunity to de-lever over time and cannot account for faster speeds on newly originated and securitized collateral. While anecdotal, there is speculation among investors that elevated prepayments that are popping up in newly originated loans are borrowers using the equity in their existing home as a downpayment for a new one, effectively using the second lien as bridge equity for the purchase of a new home that gets prepaid when the borrower sells the home by which the second lien is collateralized.
Furthermore, this borrower behavior appears to be more prevalent on loans originated through third party channels. Controlling the universe for loans between 0 and 6 WALA, loans originated by brokers do pay substantially faster at-the-money than loans originated through retail channels and modestly faster than those delivered by correspondents, suggesting there may be some substance to this conjecture (Exhibit 5). Policing this type of borrower behavior will ultimately fall back on the originators and their network of brokers. However, given the substantial premiums at which second lien pools trade, originators should have substantial incentive to keep any exogenous form of prepayment contained.
Exhibit 5: Newly originated TPO loans prepay faster at-the-money
Source: Santander US Capital Markets, CoreLogic LP
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