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Voluntary Prepays May Grow in Near Term, Credit Suisse Says

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Investors can look forward to continued tight mortgage-backed securities (MBS) spreads to treasuries in the near-term, according to a market research note Thursday by global financial services firm Credit Suisse. But watch out for higher prepayment speeds as delinquent MBS are bought out by government-sponsored enterprises (GSEs). The US Treasury Department on December 24th announced it was raising GSE portfolio caps, adding to an "impressive" tightening trend across MBS spread sectors. The spread of MBS basis to Treasuries is now at 60 bps (pictured above) and should remain tight or potentially move tighter in the near-term, Credit Suisse said. The potential for voluntary buyouts of delinquent loans by GSEs also rose since the Treasury's announcement. Credit Suisse indicates a swift buyout of the entire delinquent pipeline in January could be in the works. A February buyout, on the other hand, would provide $200bn of pay-downs for investors to reinvest by mid- to late-March. This option might be more desirable, researchers noted, as it would give investors the capital to take the Fed's place during Q210. Prepayment speeds were lower all year than initial market expectations in 2009, but investors are growing nervous over the prepayment outlook for higher coupons in 2010 as voluntary buyouts of delinquent loans look likely. "The restrictive conditions that shaped the 2009 voluntary prepayment landscape are likely to persist for some time," Credit Suisse researchers wrote. "The length of this slow prepayment window is quite uncertain, but given the overall economic and housing market outlook, we consider a two-year assumption as reasonably conservative." While Credit Suisse researchers are expecting a near-term increase in prepayment speeds, buyout-related speed increases cannot explain a notable inconsistency between realistic prepayment outcomes and durations being used by investors for higher coupons. Current hedge ratios, for example, correspond to durations of 2 years for 6s and 1.4 years for 6.5s. "We recommend going up in coupons which appear cheap on valuations and are also supported by favorable technicals," Credit Suisse researchers wrote. "However, we recommend buying in the back months as far out as possible to avoid potential losses in a voluntary buyout scenario." Write to Diana Golobay. The author holds no relevant investment positions.

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