With more than 90% of mortgages out-of-the-money from a refinancing standpoint, the MBS market has rightly focused on activities that affect discounts, including turnover and to a much lesser extent cash-out refinancings. In this analysis we examine the source of fast speeds on new issue loans and pools.
As we dig deeper on turnover, we notice a curious behavior related to curtailments that has existed for several years but gone largely ignored in recent refi-dominated environments. Curtailment activity, especially higher-than-expected curtailments on new-production mortgages, has steadily gotten stronger in more recent vintages.
For this analysis we define a curtailment as any principal payment that is larger than the contractual monthly payment but smaller than the remaining balance of the loan, which is more typically classified as payoff due to either a refinancing or house sale. In the first graph, we show curtailment speeds for new loans with note rates that were not refinanceable on a rate/term basis.1 As you can see, the 2022 vintage shows a significant uptick in curtailments in the second month. Other recent vintages show lower but still significant early-month curtailments, whereas pre-2018 vintages show very little early curtailment activity.
Digging deeper, we separate the loans by purpose: purchase vs. refi. Curtailment speeds are significantly higher among purchase loans than among refis in the first six months, with a noticeable spike at months two and three.
Focusing on purchase loans, we notice that the behavior is most noticeable for non-first-time homebuyers (non-FTHB) and relatively absent with FTHBs. The 2022-vintage non-FTHB paid nearly 6 CPR in their second month of borrowing.
What drives this behavior? While it’s impossible to say for certain, we believe that homeowners purchasing new homes are using proceeds from the sale of the previous home to partially pay off their new loan, with the sale of the previous loan coming a month or so after the close of the first loan.
How pervasive is this behavior? We looked at purchase loans originated in 2022 where the borrower was not a first-time home buyer and noted that 0.5% of the loans account for nearly 75% of the total curtailment activity on a dollar basis. That means these comparatively high, early speeds (6 CPR and higher on some pools) are driven by a small number of loans, with that vast majority of loans showing no significant curtailments in the early months.
High-curtailment loans show large payments relative to their original balances, ranging from 5% to 85% of the unpaid balance with a median value of 25%. We found no pattern with regard to either geography or seller/servicer. Looking at mortgage note rates, 80% of these high-curtailment loans were at 3.5% or lower and only 10% of these borrowers had a positive refinancing incentive at all. Only 1.5% had incentives above 25bp, with a maximum incentive of just 47bp. These curtailments are clearly not explained by rate incentive.
The relatively rarity of these curtailments means that, while in aggregate non-FTHBs are paying nearly 6 CPR in the early months, actual results within pools may vary greatly. In the chart below, we show pool speeds for 2022-vintage majors/multi-lenders, plotted against the percentage of the pool’s balance associated with non-FTHB purchases. We controlled for refi incentive by looking at pools that were out of the money by 0bp to 125bp. As the percentage of non-FTHBs in a pool increases, so does early prepayment speed, albeit with noise around the trend.
We observe that a very small percentage of non-FTHB borrowers are making large curtailment payments in the first few months after closing and that these large payments translate into a short-term pop in speeds on new production at- or out-of-the-money pools. Investors looking to take advantage of this behavior on discount MBS should focus on pools with high non-FTHB borrowers.