Mortgage-backed security investors will have to deal with higher prepayment speeds by the end of summer as the rate rally filters through to borrowers.
Though June speeds should come in flat or even slightly lower due to a reduced day count compared to May, the August report should show prepayments to be about 20% higher than current levels, according to a recent report by JPMorgan MBS strategists.
While MBS analysts from Bank of America forecast a 10% decline in conventional speeds this month led by the 2018 vintages, also due in part to a two-day reduction in day count, they, too, expect a rebound come July.
This is of the utmost importance to the sector, as one of the main variables mortgage traders must accurately forecast to properly value their investment is the speed at which the underlying home loans will be paid off. Speeds are measured by Conditional Prepayment Rates, a number which gives the annualized percentage of the existing mortgage pool expected to prepay.
It is in the more recent mortgages, specifically the 2018 and 2019 vintage 30-year 3.5% and 4% coupons, where most of the prepayment risk is considered to be concentrated. They display many 'red flags' that point to borrowers having faster response times to lower rates - such as high FICO scores and large loan sizes.
For example, Nomura's MBS strategist team predicts that while Fannie Mae 30-year 3.5% and 4% speeds will drop in June, they will ramp back up 18% and 17% higher from current levels by the end of August, with both coupons' speeds likely driven by their 2018 and 2019 vintages.
Investors could prepare for this by using specified pools, designed to protect mortgage portfolios from a spike in refinancings. A sustained rate rally through the summer months may help those securities hold or even increase in price.