What decreasing origination activity means for mortgage REITs

Market Realist

Realist mortgage applications review, September 23–27 (Part 5 of 5)

(Continued from Part 4)

Mortgage originations affect REITs in many ways

Mortgage origination activity affects REITs primarily by influencing prepayment speeds. When rates fall, the borrower can prepay the mortgage through refinancing. This phenomenon affects both agency REITs (REITs that invest in mortgage-backed securities that are guaranteed by the federal government) and non-agency REITs (which invest in REITs that bear credit risk).

Second, there are REITs like Redwood Trust (RWT) and PennyMac (PMT) that are mortgage originators. The decreasing origination activity is affecting them, as a big portion of their revenue stream is decreasing. For those that hold mortgage servicing rights, the increase in value over the past few months has offset some of this.

Effect on agency and non-agency REITs

A drop in mortgage origination activity lowers prepayment speeds, which is a positive for the REIT sector. When prepayments are high, the investor finds their high-yielding mortgage-backed security is paid off early, and they’re forced to reinvest the proceeds in a lower-yielding security. Since rates started increasing last spring, we’ve seen prepayment activity slow down markedly. On the other hand, we’ve seen house price appreciation help underwater borrowers (those who owe more on their mortgage than their house is worth) by allowing them to finally take advantage of lower rates. We’ve seen negative equity decline for the American homeowner in a big way. Given the headaches from the shutdown, refinance activity will decline, which is good for REITs.

Effect on originators

Virtually every large originator has been laying off people in response to the drop in activity. It seems every week we get another announcement from a large bank like Wells Fargo (WFC) or JP Morgan (JPM) that says they’re laying off a few thousand people. As a result, we’re seeing margins compress as originators fight for a dwindling set of loans. We’re also seeing credit standards relax as banks realize they must take more risk in order to drive revenues. The easy days of servicing a seemingly insatiable flow of streamline refinances and shoving them into a securitization at a 4 point profit are over. Now originators have to fight for every loan, and it gets difficult as rates fall and borrower renegotiate rates.

The government shutdown means originators will be able to fund loans that are pretty much ready to go, but new activity will be at a standstill until the issue is resolved. Some smaller originators are already reeling from the drop in refinance activity and the new regulatory costs imposed by the CFPB (Consumer Financial Protection Bureau). The last thing they need is a shutdown of their business for any length of time. Be wary of the originators, particularly PennyMac (PMT) and Redwood Trust (RWT).

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