A Couple Ways to Play the Coming Prepayment Rollercoaster
We mentioned last week that with the forbearance program for mortgage debtors in the recently passed CARES Act, mortgage prepayments this year could see a period of quiet then followed by faster speeds when the forbearance programs expire. That expected pattern leads to two ways to approach mortgage investments this year.
As mentioned, the CARES Act added a new forbearance program for mortgage debtors struggling financially from the fallout of the virus. Forbearance is a temporary suspension of scheduled mortgage payments that borrowers are required to eventually make up. During forbearance, servicers advance principal & interest payments on behalf of the borrower. The law provides for up to a 6 month deferral period followed by another 6 month period, if deemed necessary. Loans in forbearance jumped from 0.25% on March 2 to 3.74% on April 5. On a weekly basis, home loans backed by Ginnie Mae showed the largest growth with the share in forbearance climbing 1.58 percentage points to 5.89%. Loans backed by Fannie and Freddie increased to 2.44% from 1.69%.
During the forbearance period involuntary prepayments (foreclosure, etc.) should slow and voluntary prepays as well with the economic uncertainty of the virus hanging over the country. After the forbearance program runs its course, a delinquency buyout results in an involuntary prepayment if the borrower cannot repay the missed payments in a timely manner & the servicer determines that the loan needs to be modified.
The earliest we’re likely to see these involuntary prepayments is November which assumes a borrower throws in the towel after the initial 6 month deferral period. In all likelihood, however, there will be many more borrowers who apply for the second 6 month deferral period and thus delaying an involuntary prepayment until this time next year.
On its face there are a couple different ways to play the coming prepayment pattern:
- One way is to look for larger coupon, higher premium pools with a large and diverse pool size (possibly GNMA focused). With the higher premium and expected slowing in prepayments over the next year, book yields should lift accordingly. After six months and/or certainly a year, expect prepayments to begin accelerating. As that time approaches it may be prudent to consider trading down in coupon or other product to avoid a possible faster prepay and lower book yield scenario.
- Another way to play this outlook is less management-intensive and that is to just look for pools with the lowest coupons and more modest premiums; thus, avoiding to a degree the whole upcoming prepayment rollercoaster and the resultant impact to book yields. Of course, in both scenarios, one might want to accelerate premium amortization during the quiet period of prepayments, positioning the bond with a lower book price and less susceptible to swings in yields when involuntary prepayments accelerate.
In any event, the unfolding situation does provide the mortgage investor with options to consider. If you want to explore those options and what may be best given your existing portfolio please contact your CenterState Bank representative.