Why REITs may suffer as the MBA Refinance Index falls even as mortgage rates fall
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The Mortgage Bankers Association (MBA) Index of Refinance Activity measures application activity, not loans made. The Mortgage Bankers Association samples roughly 75% of all mortgage activity in the U.S., and its indices are key indicators for the real estate finance market and for home builders. The refinance index is released weekly, along with the mortgage applications composite index.
Housing economists use the MBA applications data to forecast many economic variables, like existing home sales and new home sales. Originators use the data to benchmark their own activities. Mortgage REITs use the data to forecast prepayment activity, which is a critical factor in mortgage-backed security returns.
The MBA Refinance Index fell 12.3% for the week ending May 24th
The Refinance Index fell to 3208 from the 3322 recorded the previous week, as the average rate on a 30-year fixed rate mortgage also increased from 4.03% to 3.94%. The ten-year bond yield rose 5 basis points to 2%. The reaction from the April Jobs Report, which seems to have been at least the initial catalyst for this sell-off, continued through last week. In fact, the average 30-year, fixed-rate mortgage bottomed at 3.4% for the week of May 1st and has steadily increased since. Ben Bernanke’s testimony in front of Congress last week raised the possibility of tapering quantitative easing in Fall. MBA reported that the share of refinance applications dropped to 71%. Most originators are anticipating a more purchase-driven market going forward and believe we’ve seen the lows in interest rates. If we have in fact seen the lows of interest rates, home price appreciation will drive refinance activity more as previously underwater home owners eventually get back to positive equity and take advantage of lower rates. Slowing refinance activity could be a negative for originators like PennyMac (PMT) and Redwood Trust (RWT).
Implications for mortgage REITs
Refinancing activity affects prepayment speeds, which is a critical driver of mortgage REIT returns. Prepayment speeds occur because home owners are allowed to pay off their mortgage early, without penalty, and when interest rates fall, those who can refinance at a lower rate will do so. This is good for home owners; however, it isn’t necessarily good for mortgage lenders, especially REITs. When home owners prepay, the investor loses a high-yielding asset and is forced to re-invest 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 Mortage Corporation (CMO).
That said, 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 are highly vulnerable to interest rate shocks.