Prepayable NHA MBS - Securitization.Net

Canadian ABS/MBS
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Securitization Files October 24, 2000
Profiting from Prepayments:
Prepayable NHA MBS
Peter Weldon
416-956-3211
Joanna Zapior, CFA
416-594-8498
Tina Lai, CFA
416-956-6273
Trevor Bateman, CA
416-594-7992
Geoff Watson, CFA
416-594-8146
MBS
prepayments
can be
beneficial to
investors in a
rising interest
rate
environment
Prepayable or open NHA Mortgage Backed Securities offer investors a way to increase
yield over Government of Canada bonds while maintaining the security of a government
backed credit. The spread over Canadas can be attributed to many factors including: less
liquidity relative to benchmarks, the amortizing feature of the bonds and the fact that payments
are monthly. While investors can always expect to receive a yield premium when
purchasing open NHA MBS, the potential for yield enhancement can increase in rising
interest rate environments.
Traditional semi-annual pay bullet bonds offer little opportunity or flexibility to investors as
rates rise. In this interest rate climate, investors are faced with the problem of selling bonds at a
loss as prices decrease or the problem of holding bonds in their portfolio which are currently
yielding less than comparable credits. The possibility of greater than expected prepayments
from prepayable MBS can prove to be beneficial in an environment where semi-annual
pay bullets are decreasing in value.
In bear markets, trading opportunities exist due to the tendency of standardized
prepayment models to underestimate the actual level of prepayments, due to the
seasoning effect on Canadian residential mortgages. The seasoning effect refers to the
propensity of mortgages in an open pool to prepay at progressively higher rates, up to a point,
throughout the term of the MBS, even when an economic incentive to refinance does not exist.
In these instances, investors can be rewarded for examining open pools and identifying those
prepaying at higher than expected levels and trading at a discount. Canada Trust pool
97000269 is one of the pools currently meeting these criteria and is an example of an MBS
we recommend based on the process of analysis outlined in this report.
Prepayable
MBS pools
The following table identifies the prepayable MBS types that do not require mortgagors to
make payments on their mortgages with strict adherence to a set amortization schedule.
Prepayments can be made against the principal amount of the loan at unscheduled intervals at
the option of the mortgagor. These pools offer investors the possibility of benefiting from
prepayments as interest rates rise. The underlying collateral in each of these pools is single
family residential mortgages.
Pool
964 Prepayable, Penalty
Interest Pass-Through Pools
967 Prepayable, No Penalty
Interest Pass-Through Pools
970 Prepayable, Indemnity
Payment Pools
Table #1-Prepayable NHA MBS Pool Types
Prepayment Options
Mortgages are open to unscheduled principal payments with a penalty interest
payment (PIP) levied on mortgagors making payments above those permitted by the
prepayment provisions. The PIP is passed on to investors.
967 pools are identical to 964 pools with the exception that any penalty interest
collected is retained by the issuer.
When PIPs are waived for competitive reasons, mortgagors can blend the original
rate with a lower rate and extend the term to five years.
When PIP is waived in the first three years, the issuer is obligated to pay a rate
differential indemnity to investors.
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For this study,
we have
eliminated
pools with
economically
motivated
refinancings in
order to
examine core
prepayment
patterns
For this study, in order to analyze the level of prepayments due exclusively to seasoning,
those open pools have been identified that offer no incentive for mortgagors to refinance.
Put another way, the pools examined in this study are out of the money. The prepayable
MBS included in this study have been selected on the basis of having a weighted average
mortgage rate (WAM) minus the prevailing five-year mortgage rate of less than 50 basis points.
Using these parameters we can be certain there are few economically motivated refinancings
because it is not financially beneficial to refinance mortgages under these conditions.
Mortgagors in these pools are deterred by the penalties and inconveniences associated with
refinancing. By eliminating refinancings that may be motivated by economic considerations,
the pattern of core prepayments over time can be examined. Core prepayments are comprised
of liquidations due to defaults, substitutions and relocation, and are generally insensitive to
interest rate changes.
Figure #1 graphs the monthly annualized liquidation rate (LQR) of out of the money, fiveyear,
open pool MBS as the pools season from the interest adjustment date (IAD), which is the
date that a mortgage in a pool is originated or renewed. The liquidation rate refers to the
percentage of mortgages on which the entire principal balance is repaid.
Figure #1 illustrates that as securitized pools of mortgages season, liquidations tend to increase
regardless of whether or not economic incentives to refinance exist. Over time, up to a point,
liquidations increase, returning unscheduled amounts of principal to MBS investors at
increasing rates. Increasing prepayments translate into quicker principal repayment for
investors, which can be desirable, particularly in a rising interest rate environment.
21%
Figure #1
Monthly Annualized Liquidation Rate (LQR)
(includes all out of the money NHA MBS pools)
18%
Liquidations (%)
15%
12%
9%
6%
3%
0%
1
4
7
Months after IAD
MBS prices are
standardized
across dealers
using the
Canadian
Liquidation
Vector model
Prepayments are expected in prepayable pools and are factored into MBS pricing by analyzing
the propensity to refinance at prevailing mortgage rates. To ensure accurate and comparable
pricing across dealers and to use prepayment assumptions which reflected historical data, the
Canadian Liquidation Vector (CLV) model was developed in June of 1998 for the NHA MBS
market and subsequently adopted by the IDA. It is important to note that the model is designed
to estimate prepayments and is more effective than constant prepayment assumptions, but is not
intended as a completely predictive model.
Figure #2 (following page) shows the Standard Canadian Curve (SCC). It is a key component
of the CLV and its shape is based on a composite of 10 years of prepayment history.
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Figure #2
Canadian Standard Liquidation Vector (CLV)
produces the
Standard Canadian Curve (SCC)
15%
Liquidations (%)
12%
9%
6%
3%
0%
1
4
7
Month
The SCC curve
is made pool
specific by
applying the
standard
multiplier to the
Standard
Canadian
Curve
Prepayments
return principal
to investors,
which is then
invested at
current interest
rates
Opportunity
exists when the
CLV differs
from the actual
data
The SCC is the core of the CLV and it is used to price MBS, in conjunction with a standard
multiplier formula which takes into account the average mortgage rate in the pool and the
current refinancing rate. The multiplier formula is as follows:
(40*(average rate in pool-refinancing rate))
Multiplier=.85*e
The multiplier standardizes prepayment expectations, which is necessary for comparable
pricing across dealers. The formula computes the level of prepayments expected at any given
difference between the average mortgage rate in the pool and the current refinancing rate. As
the refinancing rate decreases, expected prepayments increase and vice versa. It is worthwhile
to note that in the event that the rate differential is zero, prepayments are expected to occur at a
lower rate than the SCC. Expected prepayments track the SCC curve at an interest rate
differential of about 40.5 basis points.
The prepayment option, in a decreasing interest rate environment, is beneficial to borrowers as
they can refinance their mortgages at lower prevailing rates, but a detriment to investors. As
interest rates decrease, investors receive unscheduled principal payments and are forced to reinvest
these proceeds at lower interest rates. Conversely, in an increasing interest rate
environment, it is the mortgagors who have no incentive to refinance as new mortgages would
be written at higher rates than those currently contracted. Prepayments occurring in
conjunction with rising rates, particularly if they are greater than expected using the
CLV, can increase returns to investors.
The opportunity for investors, as demonstrated by our data, lies in the fact that core
prepayments increase as pools of mortgages become more seasoned, regardless of
economic incentives. In an increasing interest rate environment, liquidations in pools
trading at a discount can become a significant advantage for investors in open pool MBS.
In a bear bond market, rising interest rates decrease the value of the multiplier and produce a
liquidation vector that is below the SCC, indicating lower expected prepayments. Seasoning
has the effect of increasing core prepayments over time because they are insensitive to the
prevailing interest rate environment. Comparing specific seasoned pool data against the CLV
may indicate that prepayments have been underestimated during certain months, which could
result in underpriced securities.
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Differences
between the
LQR and the
SCC translate
into pricing
anomalies
In an increasing interest rate environment, these pricing anomalies can provide investors
with a method of receiving principal more quickly and re-investing it at higher prevailing
rates. Prepayments tend to peak between three years of seasoning and prepayment burnout,
which refers to decreasing prepayments during the final months of a pools life due to a growing
insensitivity to refinancing opportunities. Pricing anomalies should be highest during this time
frame, even where no economic incentive to refinance exists and the CLV vector is on or below
the SCC.
Figure #3 demonstrates a practical example of greater than expected prepayments using
Canada Trust Pool 97000269, which has a coupon of 5.40%. The solid line charts the
actual annualized monthly LQR and the broken line shows the expected prepayments,
using the SCC and the applicable multiplier for the pool. Prepayments have consistently
outpaced expectations in the third year of seasoning and the pool has been trading at a discount
since July of 1999. The quicker repayment of principal in a bear market environment has a
positive effect on returns through the early return of principal at par, the ability to reinvest
principal at higher rates and the reduction of duration. Prepayments appear to be peaking, as is
consistent with historical data, between the third and fourth year. The CLV, however, is
projecting prepayments lower than the SCC which provides investors with an opportunity to
take advantage of higher than expected prepayments which may not be priced into an offer.
14%
Figure #3
Canada Trust MBS Pool 97000269
Actual LQR vs. Expected Prepayments using CLV
LQR
12%
10%
8%
6%
4%
Annualized Monthly LQR
2%
0%
(SCC)*(pool 97000269 multiplier)
Sep-97
Dec-97
Mar-98
Jun-98
Sep-98
Dec-98
Mar-99
Jun-99
Sep-99
Dec-99
Mar-00
Jun-00
Sep-00
Months
Opportunities
continue to
exist
Pool 97000269 is an example of an MBS that has recently offered investors an opportunity
to exploit actual versus expected prepayment patterns. Investors purchasing pool
97000269 on June 30, 1999 would have realized an extra 3 basis points over the stated
spread as of October 16, 2000.
Table #2 (following page) provides examples of pools that may offer opportunities to take
advantage of greater than expected prepayments in the future. Each of the pools has been
identified based on the criteria outlined in this report. Each pool is currently trading at a
discount and is entering the seasoning period where actual prepayments may begin to outpace
those expected using the CLV.
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Table #2-Pools Meeting Analysis Criteria
Pool # Issuer Coupon Matures Issued
Seasoning
(months) Price Yield
Remaining
Principal
97001564 BMO 5.00% 7/1/03 2/1/99 20 97.49 6.09% $ 177,997,541
97001465 NBC 5.00% 8/1/03 12/1/98 22 97.46 6.08% $ 346,265,028
97001408 CT 5.00% 10/1/03 10/1/98 24 97.34 6.08% $ 501,893,564
97001341 CT 5.00% 7/1/03 7/1/98 27 97.47 6.08% $ 144,383,613
97001267 CT 5.00% 6/1/03 6/1/98 28 97.60 6.09% $ 189,864,807
97001259 NBC 5.38% 2/1/03 6/1/98 28 98.55 6.09% $ 143,847,205
97001234 NBC 5.38% 8/1/02 6/1/98 28 98.83 6.06% $ 180,063,465
97001192 CT 5.00% 3/1/03 5/1/98 29 97.83 6.09% $ 86,040,955
97001184 CT 5.00% 9/1/02 5/1/98 29 98.27 6.07% $ 53,405,006
97001127 CT 5.00% 3/1/03 5/1/98 29 97.95 6.09% $ 64,671,689
97001119 CT 5.00% 9/1/02 5/1/98 29 98.39 6.06% $ 51,083,063
97001101 CT 5.00% 3/1/02 5/1/98 29 98.70 6.07% $ 65,320,039
97001093 CT 5.00% 9/1/03 9/1/98 25 97.57 6.09% $ 96,203,330
97001028 CIBC 5.35% 4/1/03 4/1/98 30 98.33 6.09% $ 79,862,142
MBS
prepayment
analysis offers
actual trading
opportunities
While investors generally prefer semi-annual pay bullets, due primarily to convenience and
standardization, discounted monthly-pay open pool MBS can reduce interest rate risk in a bear
bond market.
The data demonstrates that receiving greater than expected monthly prepayments in a rising
interest rate environment can offer a number of benefits to investors. Investing in open pool
MBS as a result of careful analysis of prepayment data can be a labour intensive process but the
potential benefits are significant.
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