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MBS: Higher Coupons Could Speed Up Later • Refi risk in current coupon mortgages could cause them to trade to shorter empirical durations. Due to this factor, we maintain a neutral outlook on mortgages. • Higher coupon prepays could pick up over coming months as the credit impaired nature of such borrowers might have delayed processing. 80% 70% 60% 50% 40% Chart 1: Empirical Durations 4.0s Empr 4.0s Trader 4.5s Empr 4.5s Trader 5.0s Empr 5.0s Trader 5.5s Empr 5.5s Trader 30% 20% As shown in Chart 1, mortgages had been trading to longer durations (empirical) through June, when the market rallied but recently these durations have declined. As the low-yield scenario persisted in June, the demand for incremental yield intensified, helping mortgage spreads to tighten in the rally, leading to longer durations. Another way of looking at this is that, since the market trend was mostly a one-way rally train in June and prepayments were expected to be low, mortgages were trading with positive convexity. In the selloff that came after (preceding the most recent rally), empirical durations started coming off. Wednesday’s rally however led mortgages to widen, continuing the declining duration trend despite a rally. We think that for lower coupons, the refi risk, especially in the 08 and also 09 vintages is considerable as demonstrated in the recent prepay report, and may be contributing to this trend; indeed, it may have been a game changer. Note how as we go up in coupon the empirical durations seem to be ticking up. We expect the continued market sentiment of a slower economic recovery to push yields lower. This could increase demand for incremental yield, helping mortgage spreads to tighten. But the sceptre of higher prepays in current coupons makes us neutral on the basis, and we may consider selling mortgages on strength, should they tighten considerably in a rally. Even after the mortgage primary rate reached another all time low last week, the refi index actually declined. Borrowers are clearly not getting the full benefit of low rates. But the newer lower coupons that define the current coupon mortgage basis as such are callable, even though the mortgage universe as a whole may not be all that much callable. It is from the basis perspective that we 10% 0% 2-Apr-10 23-Apr-10 14-May-10 4-Jun-10 25-Jun-10 Source: BNP Paribas ZV OAS Chart 2: Current Coupon OAS and ZV OAS 85 80 75 70 65 60 55 50 03-May-10 24-May-10 14-Jun-10 05-Jul-10 Source: Yield Book ZV OAS OAS expect 4s and 4.5s to trade to shorter durations in a rally. Since MBSPP proceeds are not reinvested, increased prepays increase the net supply to the market, which is negative for mortgages. Otherwise, the Fed put to bed any imminent expectations of MBS sales in its latest minutes and re-iterated that monetary tightening will take place first before assets sales begin. The Fed also left the door open to more accommodative policy if the economy gets worse, but extending mortgage purchases is only a probability at this point. Overall, these factors also favour a neutral outlook. Along the coupon stack we continue to like 5 and 5.5s, which have not completely recovered from the levels before the Fed started its coupon swap activities. As we have mentioned in the past, the Fed was selling rolls so as to not force dealers to deliver. However, system-wide fails had persisted despite the selling of rolls, and should continue despite coupon 16 14 12 10 8 6 4 2 0 -2 -4 OAS Anish Lohokare/Olurotimi Ajibola 16 July 2010 Market Mover, Non-Objective Research Section 26 www.GlobalMarkets.bnpparibas.com
swaps. The overall volume of USD 9.2 bn was small compared to the system-wide fails. Granted, a chain of fails can show up as an artificially high number but the magnitudes are clearly a multiple. While convexity is a concern in these coupons, the limited response to lower rates and the reduced float will only serve to exacerbate the squeeze in the coupons. Could refi's on higher coupons pick up in coming months? In a pre-prepay note, we had discussed that banks may have processed applications quicker in June to save capital by converting loans to MBS. This may have caused elevated June supply, possibly causing prepays to come in higher than expected (June borrowing prepays from July). Prepays on lower coupons did come in faster than expected but those on higher coupons didn’t. However, if banks did indeed process applications quicker, those with cleaner credit would have likely been processed more easily. This may explain the sharp discrepancy in prepays in the coupon stack. In fact based purely on the relationship between the refi index and prepays (adjusted for business days), it appears that the lag between prepays and the refi index was shorter than the typical 45 days (Chart 3). This could have essentially been magnified in lower coupons at the expense of higher coupons. In Figure 4, we show how prepays ramped in late 2008-early 2009. It shows that higher coupons took more time in ramping up than lower coupons. Chart 5 shows that the acceleration of CPR for the 6.5% coupon is lagging the 5%, 5.5% and 6% coupons during the December 2008 spike. The best way to compare it is to use the following calculation: CPR_month_(t-1) – 2 x CPR_month_(t) + CPR_month_(t+1). As clearly shown in the table, the acceleration of CPR for 6.5% coupon is much lower in the month of December and it is the only positive one in January. Chart 3: 4-Week Moving Average Change in Refi Index for Different Lag Periods Refi Index( Chg) 80% 60% 40% 20% 0% -20% -40% -60% Feb-09 May-09 Aug-09 Nov-09 Feb-10 May-10 Source: Bloomberg, BNP Paribas 45 Day Lag 4 Week Average 30 Day Lag 4 Week Average Chart 4: Prepayment Speeds by Coupon CPRs 40 35 30 25 20 15 10 5 0 Nov- 08 Dec- 08 Source: eMBS, BNP Paribas Jan- 09 Feb- 09 Mar- 09 Apr- 09 May- 09 5 5.5 6 6.5 Jun- 09 Chart 5: Acceleration of Prepayment Speeds by Coupon (CPR_month_(t-1) – 2 x CPR_month_(t) + CPR_month_(t+1)) Coupon Feb-09 Jan-09 Dec-08 5.0 -8.7 -4.6 8.9 5.5 -9.9 -6.6 10 6.0 -6.8 -4.1 6.3 6.5 -7.6 2.8 3.8 Source: eMBS, BNP Paribas This effect may be particularly magnified this time around, given that the GSEs seem to be pursuing reps and warrants, including the repurchase of loans not underwritten to their standards. Prepays on higher coupons may thus surprise to the upside over the coming months. Also note that negative seasonals come into play for delinquencies, a fact reflected better in the FG delinquency numbers last month. Anish Lohokare/Olurotimi Ajibola 16 July 2010 Market Mover, Non-Objective Research Section 27 www.GlobalMarkets.bnpparibas.com
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