As a solid year for the mortgage-backed securities market draws to a close, a rise in loan prepayments has some on Wall Street looking ahead with some trepidation.
Through Dec. 22 mortgage-backed securities issuance stood at $192.6 billion, well ahead of 1996 volume of $101.0 billion but far short of 1994's record $415 billion, according to Securities Data Co.
Single-family mortgages performed well in 1997 as spreads widened, but prepayment worries have already prompted some investors to replace mortgages in their portfolios with other fixed-income products, said Craig S. Phillips, managing director at Morgan Stanley, Dean Witter, Discover & Co.
When loans are prepaid, mortgage-backed-security investors receive the principal back faster than anticipated. Maturity, or the duration of cash flows, shortens, translating to a lower rate of return on most securities.
"Given the low-rate environment that prevails, prepayment activity remains at a very high level, which will weigh on returns," said Mark Zandi, vice president and chief economist of Regional Financial Associates in West Chester, Pa. He noted that long-term rates had declined by about 100 basis points in 1997.
Mortgage volume was higher in 1994 due to prepayments, but many investors were hurt.
The prepayment trend this year has been worsened by volatility in the Asian markets, which has driven U.S. interest rates lower, and by new technologies that let consumers obtain loans over the Internet or by calling a toll-free number.
"There is concern that with all this technology that exists in the mortgage world, the refinancing process has become even more efficient," said Anand K. Bhattacharya, managing director and manager of fixed-income research and product management at Prudential Securities.
"In the last few months, the yield curve has flattened, and with low rates in general there has been greater concern" about mortgage prepayments, especially for securities based on adjustable-rate mortgages, said T. Anthony Coffey, a portfolio manager at Franklin Templeton Group in San Mateo, Calif.
Technological advances continue to help Wall Street firms accomplish their work with fewer and more junior people. But it also lets customers do their own research and rely on Wall Street primarily for transactions, said Mr. Phillips.
Consolidation among financial firms means fewer investors-and more originators with the sophistication and clout to bring securities directly to investors - bypassing Wall Street firms, Mr. Phillips said. In addition, there is some fear that Fannie Mae and Freddie Mac will become direct originators, he said.
Still, managing directors for mortgage-backed securities on Wall Street remain optimistic for 1998.
They note that prepayments mean more volume for Wall Street firms that package loans for resale on the secondary market. And because investors are getting a lot of money back, they then have cash to reinvest.
In 1997 a big emphasis was placed on emerging markets and finding yield internationally, said Prudential's Mr. Bhattacharya. He predicted a stronger domestic focus in 1998.
"Event risk on the corporate world has surfaced again," said Mr. Bhattacharya. "Going forward, I think next year could really be the year of mortgages, but it might take a while for some of this stuff to get flushed out because of prepayment concerns."
Salomon Smith Barney has been the No. 1 manager of mortgage-backed securities in 1997, with $30 billion of issuance through Dec. 22.
Lehman Brothers Inc. was ranked second, with $25.4 billion, followed by Bear, Stearns & Co., with $22.7 billion.