September 23, 2014
By Bob Judge
Editor, CPR Report
The geeks among you are going to love this chart.
Over the past few months, we are always being asked the biggest question in the secondary market:
What will happen when rates rise?
While we don’t have a crystal ball, looking into the past would seem the best place to search for an answer. For this reason, we have “enhanced” our CPR Report historical graph. While the old one only went back to 2009, we dug deep into our pricing database and pushed back the data to August, 1999. Additionally, we have also included the six-month historical prepayment speed and the Prime Rate to give perspective to the pricing data.
While no two historical periods can ever be considered identical, the period between May, 2004 and June, 2006 represents the only prolonged period of rising interest rates, as represented by the Prime Rate, during the past 15 years. During this time period, the Prime Rate rose 425 basis points, going from 4% to 8.25%.
So, what happened during this two year period?
• Over those 25 months, the average CPR rose from 11% to 19.70%, an increase of 79%. This increase was primarily the result of rising voluntary prepayments fueled by a flat yield curve and unprecedented access to capital for small business borrowers.
• Secondary market pricing, as represented by a 25-year, 2.75% gross margin loan, fell from 115.75 to 114.69, a decrease of only .92%. This, in the face of a near-doubling of the prepayment speed. While no one knows the exact cause of this small decrease, it would seem to be a mix of high demand for variable-rate assets in a rising rate environment combined with an asset bubble in financial assets.
Turning to the chart for a moment, there does seem to be a positive correlation between interest rates and prepayment speeds. However, market pricing shows no correlation with either.
So, what does this all mean for pricing in a rising rate environment?
• Rising rates should bring about higher prepayment speeds, fueled by voluntary prepayments as borrowers move into fixed rate loan products. However, we do not expect anything close to the increase in prepayment speeds seen in 2006.
• As long as prepayment speeds don’t go ballistic, demand for high-quality, floating-rate assets in a rising rate environment should keep pricing within 5% of today’s levels.
That is my prediction. Just don’t hold me to it.
Lastly, we have also added a similar analysis for 504 debentures, which, as fixed rate assets, are strongly correlated with interest rates. In this market, weighted-average pricing has to be looked at in terms of the weighted-average coupon, which slowly rises and falls with market level interest rates as new pools are formed and sold into the market.