- A rising-rate environment in 2021, along with uncertainty over refinance burnout, reversed the prepayment trajectory of U.S. agency mortgage-backed securities.
- We reviewed the MSCI prepayment model’s performance for 2021, to show historical error tracking within the model’s acceptance criterion and consistency with market-implied pricing.
- A historically validated model will be a valuable risk management foundation for the potentially volatile year ahead of us.
The U.S. economy proved extraordinarily resilient through 2021, and the market for U.S. agency mortgage-backed securities (MBS) was dominated by expectations of persistently higher inflation. As we now face a potentially imminent reversal in Federal Reserve monetary policy, with more aggressive measures to combat inflation, we review the performance of the MSCI Agency Fixed Rate MBS Prepayment Model, to assess its relevance and accuracy and help MSCI clients manage MBS risk through what could be a volatile 2022.
The rise of 10-year Treasury rates and MBS current coupon yields have pushed the primary 30-year mortgage rate above 3.5%, the highest since March 2020. Agency-MBS prepayment, in general, trended down through 2021. The uncertainty of prepayment burnout has been a key topic among market participants. The conventional 30-year prepayment rate dropped from the peak conditional-prepayment rate (CPR) of 37 to 20 CPR by the end of 2021, and the downward trend continued into 2022 with a print of below 15 CPR for January. Have we entered a new prepayment regime, after the historic mortgage-origination years of 2020 and 2021?
Rates have risen since late 2020, amid inflation concerns and Fed policy changes
Higher rates slowed prepayment of agency MBS through 2021
Source: Fannie Mae, Freddie Mac, MSCI
The exhibit below shows the weekly Mortgage Bankers Association’s Refinance Mortgage Application Survey Index versus interest rates, grouped into three periods:
- August through December 2020: the typical refinance wave during the pandemic
- January through April 2021: the height of the COVID-19 refinance wave
- May through December 2021: the refinance period as rates rose and burnout kicked in
The scatter plot below illustrates how refinancing weakened in the second half of 2021, to levels significantly lower than the refinance index in earlier periods at the same mortgage rate. For instance, at mortgage rate = 3%, this analysis shows the refinance was 17% lower in later 2021.
An early sign of refinance burnout?
Source: Mortgage Bankers Association, Freddie Mac, MSCI
As rates rose through 2021, prepayment speeds came down significantly. The exhibit below shows the model’s performance using rank-based error tracking, by quarter, in 2021. The MSCI model was able to track the prepayment peak in the first quarter. As rates rose and burnout started to pick up in the subsequent three quarters, the MSCI model tracked this trend as well. The average absolute error was 0.3 single monthly mortality, which is within the model’s acceptance criterion.
The MSCI prepayment model tracked the actual slowdown
Source: MSCI Agency Fixed Rate MBS Prepayment Model
Option-adjusted duration (OAD) is the measure of interest-rate risk that market participants commonly rely on. It is often modeled using Monte Carlo simulations with a prepayment model and a stochastic term-structure model for swap rates and mortgage rates. But OADs can differ greatly across models, due to differences in modeling assumptions and techniques. As a reality check on the model performance, we can derive the empirical duration by regressing securities’ historical price changes against changes in the rates of swaps and Treasurys as an ex-post measure.
A reality check on MBS durations with empirical duration
UMBS 30yr 2.5% Coupon
Source: MSCI Agency Fixed Rate MBS Prepayment Model, MSCI Two-Factor Interest Rate Model
The exhibit above shows that the OAD based on the MSCI model suite tracked empirical duration closely through most of 2021. This implies the model’s assumptions that are beyond historical data fitting, such as forward-looking long-term primary-secondary spread and changes in underwriting standards, were consistent with market dynamics.
In summary, we reviewed the MSCI agency prepayment model’s performance. Both historical prepayment error tracking and a reality check against empirical duration implied by market pricing showed the MSCI agency prepayment models performed as expected, meeting our model-validation standard. Investors may wish to turn to historically validated risk-management models for riding rising interest rates through a potentially volatile year ahead.