By the Numbers
Value in non-QM prepay penalties as home price appreciation slows
This material is a Marketing Communication and does not constitute Independent Investment Research.
Investors in non-QM trusts backed by investor loans have exposure to collateral that, for the most part, carries prepayment penalties. But current market pricing suggests bond investors ascribe little to no value to these penalties, perhaps because strong home price appreciation in recent years has reduced the penalties’ effect. With home price appreciation likely slowing, the value of non-QM penalties should rise.
Prepayment penalties at a glance
Non-QM securitizations are somewhat unique in the broader MBS securitization ecosystem in that they are one of the very few exposures where loans on single-family homes can carry prepayment penalties. Prepayment penalties were commonplace in pre-crisis private MBS transactions. But subsequent Dodd-Frank legislation precluded mortgage originators from attaching those penalties to consumer loans going forward. Investor loans on single-family residences are somewhat unique in that they fall outside the scope of the Dodd Frank legislation and the Qualified Mortgage rules as they are considered business purpose loans and can carry prepayment penalties, like multifamily and other commercial real estate loans. Prepayment penalties on non-QM investor loans are also structurally similar to those found in commercial real estate in that they come in different tenors and the cost of the penalty may remain fixed or decline over that tenor.
Valuing prepayment protection
The most simplistic way to value prepayment penalties is to compare prepayment rates on loans that carry prepayment penalties relative to those without penalties given the same amount refinancing incentive. Given differences in risk-based pricing on non-QM whole loans, refinancing incentive is valued net of those difference or ‘SATO-adjusted.’ With the caveat that this analysis does not control for other loan attributes like loan size and age that will have some impact on prepayment speeds, non-QM loans with prepayment penalties pay substantially slower both at- and in-the-money than those without. At-the-money speeds on loans with penalties are roughly 15 CPR slower than no penalty loans. And that differential remains roughly consistent as refinancing incentive increases (Exhibit 1).
Exhibit 1: Non-QM loans with penalties pay 15 CPR slower at-the-money
Source: Santander US Capital Markets, CoreLogic Loan Performance
Another key factor that the above analysis does not account for is the loans’ mark-to-market LTVs. And one plausible reason as to why the market has not historically ascribed substantial value to prepayment penalties is that investor loans that carry both prepayment penalties and significant amounts of mark-to-market equity prepay very fast. The explanation for this is a fairly simple one in that investors will gladly pay a 5-point or, in some instances, smaller penalty to unlock 20 or more points of equity, which the investor can then invest in an additional property and re-lever the existing one.
By creating a cohort of loans with prepayment penalties and original LTVs between 70 and 80 and then generating prepayment S-curves based on mark-to-market LTV illustrates the prepayment incentive that trapped equity creates on these loans. Prepayment penalty loans that carry 30 or more points of mark-to-market equity prepay at upwards of 65 CPR with no rate incentive. And both in and out-of-the-money speeds are fairly consistent with at-the-money ones. Conversely, loans with current LTVs that are in-line with their original ones prepay slower than 12 CPR at-the-money and just 15 CPR with 75 bp of refinancing incentive (Exhibit 2).
Exhibit 2: Trapped equity offsets the value of prepayment penalties
Source: Santander US Capital Markets, CoreLogic Loan Performance
The pronounced difference in speeds on loans that have experienced substantial home price appreciation versus those that have not suggests that the value of prepayment penalties should increase as home price appreciation slows and become far less valuable as it increases. With CoreLogic forecasting a 3.6% increase in home prices nationally this year, the amount of equity investors build this year could fall short of the value of a prepayment penalty, suppressing prepayments on these investor loans.
Penalty term matters too
While borrower equity looks to have the most meaningful impact, certain other factors influence how effective penalties are in suppressing prepayment rates. The term of the prepayment penalty looks to carry substantial weight. Prepayment penalties on non-QM investor loans tend to be structured with either 3- or 5-year terms and either carry a fixed penalty or declining point structure, meaning the penalty the borrower must pay to prepay the loans declines by one point every year the loan seasons. Loans with 5-year prepayment penalties prepay near zero at-the-money with peak speeds of roughly 9 CPR observed when the borrower has 25 bp of refinancing incentive. Conversely, loans where the remaining penalty term is a year or less prepay at 16 CPR at-the-money with speeds increasing to 32 CPR when borrowers have more than 100 bp of incentive to prepay (Exhibit 3).
Exhibit 3: Prepay penalty term matters
Source: Santander US Capital Markets, CoreLogic Loan Performance
One challenge investors may be faced with when trying to value prepayment penalties is empirical models may not be providing sufficient value to them. Running the ‘AAA’ classes of EFMT 2025-INV5, a deal fully collateralized by investor loans where the majority carry prepayment penalties, and EFMT 2025-NQM5 transactions through Yield Book’s OAS model shows very little difference in long-term speed or option cost even when running both bonds to maturity (Exhibit 4). If the dispersion in empirical speeds between loans with penalties relative to those without continues to hold or widens further, it seems plausible that model updates will better capture this, lowering option cost and increasing OAS on bonds backed by these loans.
Exhibit 4: Models may not be capturing convexity from penalty loans
Source: Santander US Capital Markets, Yield Book
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