A review of mortgage applications for the week of December 8 (Part 4 of 4)
The Mortgage Bankers Association (or MBA) Refinance Index was flat at 1,519 after last week’s big jump. Since mid-2013, refinances have been dropping like a stone since the people who have home equity have already refinanced and the ones left with high rates are underwater.
The MBA reported that the share of refinance applications increased to 66.4%. This bond market rally has caught many by surprise, but it could be a pleasant surprise for the originators, who have had a horrendous year. Slowing refinance activity was a negative for originators including PennyMac Mortgage Investment Trust (PMT), Nationstar Mortgage Holdings, Inc. (NSM), and Redwood Trust, Inc. (RWT). The question is, how many people are left to refinance? It could be more than you think. Home price appreciation and easier lending standards will allow those who were unable to participate in the refinance wave last time around finally get their chance.
Refinancing activity affects prepayment speeds, which are a critical driver of mortgage real estate investment trust (or REIT) returns. Prepayment speeds occur because homeowners are allowed to pay off their mortgages early without penalty, and when interest rates fall, those who can refinance at a lower rate do. This is good for homeowners, but it isn’t necessarily good for mortgage lenders, especially REITs.
When homeowners prepay, the investor loses a high-yielding asset and is forced to reinvest the proceeds in a lower-rate investment. This means lower returns going forward. A rise in prepayment speeds could negatively affect REITs, including American Agency Capital Corp. (AGNC), Annaly Capital Management, Inc. (NLY), Hatteras Financial Corporation (HTS), CYS Investments, Inc. (CYS), and Capstead Mortgage Corporation (CMO).
That said, the increase in rates has basically put prepayment worries on the back burner for REITs. The lack of a reaction in the refinance index on the back of a drop in rates could mean we’re finally seeing prepayment burnout. This would be good news for REITs.
As rates increase, prepayments become less of a problem for REITs. Yet increasing rates brings its own set of problems. REITs face mark-to-market portfolio hits and must adjust hedges to a more volatile interest rate environment. Mortgage-backed securities outperform in stable interest rate environments, but they’re highly vulnerable to interest rate shocks.
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