Ginnie adjustables likely to show stable prepayments.

The following article is adapted from pone that appeared in the Aug. 20 issue of Prudential Securities' "The Mortgage and Asset-Backed Market Review."

Many investors now fear that an increase in short-term rates, together with a flattening of the yield curve, could result in a significant rise in refinancing of adustable-rate loans into fixed-rate mortgages.

In this event, there could be a significant increase in prepayments for conventional adjustable-rate mortgages.

Investors who are concerned about such a possibility should consider the slower-prepaying Ginnie Mae adjustables market, Within this market, prepayments are expected to remain relatively stable, even for newly originated, fully indexed 5.5% and 6% coupons.

Holding Steady

In contrast to the fixed-rate market, the last two years have seen relatively stable prepayments for most sectors of the ARM market.

One of the factors that has kept ARM-refinancing activity light over the last 2 1/2 years has been the decline in primary-market mortgage rates for ARMS, which has closely tracked the decline in 30-year fixed rates.

In fact, the current spread between Freddie Mac's survey of 30-year fixed and one-year adjustables is currently more than 260 basis points, well above the three-year and five-year historical averages of 243 and 213 points.

Causes for Stability

If the spread between 30-year fixed and one-year adjustable rates remains at or close to current levels, we expect ARM prepayments to remain stable for the following reasons:

* Many homeowners who take out ARMs are attracted by the low initial teaser rates that typically are offered for the first year. They include first-time buyers and others who are unlikely to refinance into a higher-coupon fixed-rate product unless short-term mortgage rates are comparable to long-term rates.

* The surge in ARM prepayments in the spring of 1991 satisfied much of the refinancing demand from those wanted to lock in fixed-rate loans below 10%.

* Much of the outstanding ARM securities come from mortgages that were originated from mid-1987 through early 1989, when the adjustables' share of primary-market originations was above 50%. These loans currently have four to six years of seasoning and should show fairly stable prepayments.

Other Possibilities

If, however, the curve flattens significantly and short-term rates rise sharply, we would expect the following:

* Prepayment speeds on both fully indexed convertible and nonconvertible one-year CMT ARMs would increase substantially. However, for seasoned convertible ARMs, we would expect speeds to increase much more than nonconvertible speeds as the conversion option to a fixed-rate mortgage is exercised.

* Adjustables indexed off the six month Treasury bill or CD rates should be among the first sectors of the market to experience a significant increase in prepayments.

This is because, in a rising interest-rate environment, the semiannual coupon-reset feature of these ARMs would result in a more rapid adjustment to higher rates for borrowers with these mortgages compared to those with those that reset annually.

Conversely, those that reset every three or five years arc likely to experience a more delayed increase in prepayment rates.

* Prepayment speeds on adjustables indexed to the cost of funds and on Ginnie Mae ARMs would likely increase less than those on conventional-CMT or CD ARMs.

Ginnie Mae mortgagers in general tend to be less sensitive to refinancing opportunities than conventional mortgagers.

As a result, their prepayments historically have been less volatile, as well as slower. than prepayments on conventional ARMs.

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