Why rising default rates might not be bad for subprime MBSs

Understanding mortgage-backed securities is hard. They don’t behave like normal fixed-income instruments: even now, with subprime defaults soaring, the big risk on MBSs is prepayment, not borrower default. And research on MBSs frequently includes passages like this:

6-wala FN 6s have a gross WAC of 6.66%, while 10-wala FN 6s have a gross WAC of only 6.46%. But could 20bp of WAC explain why the 6-wala pools are prepaying at 19 CPR while the 10-wala pools are prepaying at 13 CPR? The short answer is no.

Got that? I’ll explain it to you if you want: people with mortgages written 6 years months ago are much more likely to refinance or otherwise prepay their loans than people with mortgages written 10 years months ago. Part of the explanation is that they took out their loans at higher interest rates, so they have more incentive to refinance. But that can’t be the whole explanation.

But all that is pretty much beside the point. My bigger point is that MBSs are a world unto themselves, and you can’t just jump willy-nilly from the fact that default rates are rising to the conclusion that the world of MBSs is doomed. In fact, the fact that default rates are rising is consequence largely from the fact that it’s becoming increasingly difficult for subprime borrowers to refinance. And fewer refinancings means fewer prepayments — and fewer prepayments could mean that subprime MBSs are actually more attractive than they were. Here’s Merrill Lynch:

Remember the good old days when lower credit borrowers were assumed to be slower in speed? When borrowers with high LTVs found it difficult to refinance or take cash out? When alt-A premium mortgage pools traded with a premium in price?

All of these ideas were predicated on the concept that a borrower who had low documentation, worse credit, or high LTV, either did not have as many opportunities to refinance or were on average less financially sophisticated and consequently less aware of movements in interest rates.

Over the past few years, however, this principle was stood on its head. With home prices rising relentlessly and lending standards generally easing over time, these borrowers became among the faster prepaying loans. They were eager to take cash out and/or trade up, and they were certainly the target of numerous mortgage solicitations by brokers. In contrast, more traditional prime borrowers who had less need for cash were likely to prepay slower during this period.

Are we drawing to the close of this rather remarkable period? Now that everyone is promising tighter underwriting standards, it seems likely to us that prepayments on more marginal borrowers are likely to decline as well. This suggests that premiums backed by these pools may once again turn out to have value.

I’m not saying that subprime MBSs are a screaming buy — and neither, I hasten to add, is Merrill Lynch. But this kind of dynamic is worth bearing in mind before anybody starts jumping to conclusions about the effect of rising default rates on the market in mortgage-backed securities. Norris, I’m looking at you.