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Will Mel Watt save the day for originators as refinances rise?

Brent Nyitray, CFA, MBA

Mortgage Applications Review, December 2–6 (Part 4 of 4)

(Continued from Part 3)

The MBA Refinance Index rises is spite of higher interest rates

The Refinance Index rose 2% (from 1,602 to 1,635), even though rates were up 10 basis points. The bond market has been readjusting to the idea that we may see the end of quantitative easing soon, and it is dawning on people that the low rates we saw earlier this year are not coming back.

The MBA reported that the share of refinance applications rose to 64.6%. Going forward, home price appreciation will drive refinance activity as previously underwater homeowners eventually get back to positive equity and take advantage of lower rates. Slowing refinance activity will be a negative for originators like PennyMac (PMT) and Redwood Trust (RWT). It has already taken its toll on Nationstar (NSM), which reported disappointing earnings.

Policy could have an impact, though. President Obama gave a speech regarding housing in which he said he wants everyone to be able to refinance. That means HARP 3.0 (another wave of the Home Affordable Refinance Program), which would presumably extend to non-government mortgages and would have a later cutoff date than early 2009. If this happens, expect another refinance wave. This would be music to the ears of mortgage originators, and it helps explain why the Mortgage Bankers Association endorsed Watt as the next FHFA Chairman.

Implications for mortgage REITs

Refinancing activity affects prepayment speeds, which are a critical driver of mortgage REIT returns. Prepayment speeds occur because homeowners are allowed to pay off their mortgage early, without penalty, and when interest rates fall, those who can refinance at a lower rate do. This is good for homeowners. However, 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, like American Agency Capital Corp. (AGNC), Annaly Capital Management, Inc. (NLY), Hatteras Financial Corp. (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.

However, as rates increase, prepayments become less of a problem for REITs. But increasing rates bring their own set of problems, and REITs face mark-to-market hits on their portfolio and must adjust their 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. As we’ve seen from the mortgage REIT earnings so far, virtually everyone is reporting a substantial decline in book value, as higher rates have taken their toll. It would be ironic to see the only silver lining of increased rates (lower prepayment speeds) taken away from the REITs as well.

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