By the Numbers
Low WALA and purchase loans drive faster second lien prepayments
This material is a Marketing Communication and does not constitute Independent Investment Research.
At-the-money prepayment speeds on recent second lien mortgages are more than 30% faster than pricing conventions on second lien securitizations. Newly originated loans, especially ones used to purchase a home, seem to be driving the faster speeds. But this phenomenon does not appear to be the same across all originators. Loans originated by Mr. Cooper, SpringEQ and PennyMac show slower at-the-money speeds than others.
Investors at the top of the capital structure in second lien securitizations are insulated from fast prepayments to some degree as coupons on investment grade debt are optimized for par pricing at issuance. Subordinate bond investors have benefitted from faster speeds as faster prepayments de-lever the open window ‘AAA’, building credit enhancement for investors lower in the capital structure. However, equity investors have likely seen elevated speeds, particularly on newly originated loans, erode returns if those investors assumed it would take longer for prepayments to ramp up.
A high-level look at second lien speeds
Non-agency investors likely ascribe significant value to second lien collateral as both floating-rate HELOCs and fixed-rate closed-end second lien loans both exhibit very flat prepayment S-curves. The out-of-the-money speeds on these types of loans are bolstered by borrowers who look to extract additional home equity while in-the-money speeds get suppressed by fixed costs associated with refinancing smaller balances. Floating-rate HELOCs prepay faster across all observations of relative moneyness, but some of that differential can be explained by the fact that prepayments are calculated based on the initial securitized balance and do not factor in subsequent draws on the untapped balance (Exhibit 1).
Exhibit 1: HELOCs prepay faster than closed end second liens
Source: Santander US Capital Markets, Core Logic Loan Performance
Note: S-curve observations are over a two-year horizon from January 2023 through December 2025. Incentive is SATO adjusted. Incentive for floating-rate collateral is calculated based on the prevailing fixed 30-year PMMS rate at time of abatement.
Digging in on second lien collateral attributes
With cohort level at-the-money speeds hovering around 20 CPR, roughly one third faster than pricing conventions of 15 CPR, the prepayment dynamic in second liens merits a more granular look into what loan attributes are driving these faster speeds. One interesting phenomenon observed in second lien prepayments is the presence of elevated at-the-money speeds on purchase loan second liens. Second liens put in place when a borrower purchases a home have prepaid at 31 CPR, 12 CPR faster than loans that were used for equity extraction and 19 CPR faster than loans where the borrower refinanced their second lien (Exhibit 2).
Exhibit 2: Purchase loans pay faster than rate and cash-out refinances
Source: Santander US Capital Markets, Core Logic Loan Performance
Note: S-curve observations are over a two-year horizon from January 2023 through December 2025. Incentive is SATO adjusted. Incentive for floating-rate collateral is calculated based on the prevailing fixed 30-year PMMS rate at time of abatement.
While somewhat anecdotal in nature, there are likely a couple circumstances that could drive elevated speeds on purchase loan seconds. A borrower could take out subordinate financing to perform renovations on a purchased home and, on completion of those capital expenditures and subsequent increase in the home’s value, the borrower may be able to consolidate the existing first and second liens into a lower rate than the blended cost of financing on the two loans. Secondly, the majority of closed end second liens are originated on the back of loans with conventional conforming balances. Given the relatively small balances on these second liens, increases in FHFA conforming limits could trigger the ability to consolidate the second lien into a single GSE-eligible loan if conforming limits increase enough to do so. Interestingly, the differential in prepayment rates between HELOCs and closed end second liens is far more muted on purchase loans with at-the-money speeds on purchase HELOCs coming in at 31 CPR versus 29 CPR for closed-end loans.
Another curious phenomenon is the presence of somewhat substantial prepayments in newly originated second liens. Loans seasoned less than three months are prepaying at 10 CPR at-the-money while loans with three to five months of seasoning are prepaying at nearly 15 CPR (Exhibit 3). Once again while somewhat anecdotal in nature, it appears that borrowers may be using second liens as some form of bridge financing, potentially using equity from one property to fund the purchase of another and then paying down the second lien debt once permanent financing is secured for the second property.
Exhibit 3: Low WALA loans prepay fast in second lien trusts
Source: Santander US Capital Markets, Core Logic Loan Performance
Note: S-curve observations are over a two-year horizon from January 2023 through December 2025. Incentive is SATO adjusted. Incentive for floating-rate collateral is calculated based on the prevailing fixed 30-year PMMS rate at time of abatement.
And combining the two loan attributes magnifies the effect. At-the-money prepayment rates on zero to two WALA purchase second liens are nearly 34 CPR. While three to five WALA purchase second liens prepay nearly 39 CPR at-the-money (Exhibit 4). Admittedly, the majority of second liens being securitized are cash out refinances where the phenomenon is far more muted and in-line with the above cohort level analysis.
Exhibit 4: Low WALA purchase loans prepay upwards of 35 CPR at-the-money
Source: Santander US Capital Markets, Core Logic Loan Performance
Note: S-curve observations are over a two-year horizon from January 2023 through December 2025. Incentive is SATO adjusted. Incentive for floating-rate collateral is calculated based on the prevailing fixed 30-year PMMS rate at time of abatement.
Originators matter
Elevated prepayments are by no means a universal phenomenon across the cohort of securitized second liens. And one of the biggest observable drivers of more muted speeds can be seen when cutting the universe by originator. Mr. Cooper stands out as having by far the slowest at-the-money speeds, prepaying at just 12 CPR, roughly 40% slower than the broader cohort. PennyMac and SpringEQ originated loans stand out as being significantly slower than cohort as well, prepaying at 16 and 17 CPR respectively at-the-money (Exhibit 5).
Exhibit 5: Prepayment S-curves vary significantly by originator
Source: Santander US Capital Markets, Core Logic Loan Performance
Note: S-curve observations are over a two-year horizon from January 2023 through December 2025. Incentive is SATO adjusted. Incentive for floating-rate collateral is calculated based on the prevailing fixed 30-year PMMS rate at time of abatement.
Elevated speeds across other originators could be a function of a number of factors. Greter efficiency and lower costs and frictions associated with refinancing can certainly be one. Differences in original LTV could be another as loans with higher original LTVs can roll down a steep risk-based pricing curve as the loan de-levers. And how active an originator is in soliciting refinances could be another. With that said, investors in different portions of the capital structure will likely favor certain originators over others given potential upside or downside to faster speeds.
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