Refinances collapse as bond market rout continues
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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 home builders. The refinance index is released weekly, along with the mortgage applications composite index.
Housing economists use the MBA applications data to forecast numerous economic variables, like existing home sales and new home sales. Originators will use the data for benchmarking their own activity. Mortgage REITs will use the data to forecast prepayment activity, which is a critical factor in mortgage backed security returns.
The MBA Refinance Index fell 15% for the week ending May 31st
The refinance index fell to 3163 from 3723 the previous week as the average rate on a 30-year fixed rate mortgage also increased from 3.75% to 4.1%. The 10-year bond yield rose 12 basis points to 2.1282%. 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 on May 1st and steadily increased since. Ben Bernake’s testimony in front of Congress last week raised the possibility of the tapering quantitative easing in the Fall. MBA reported that the share of refinance applications dropped to 68%. Most originators are anticipating a more purchase-driven market going forward and believe we have seen the lows in interest rates. If we have in fact seen the lows of interest rates, refinance activity will be driven more by home price appreciation, as previously underwater home owners eventually get back to positive equity and can 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 are altered when home owners pay off their mortgage early; they are allowed to do so without penalty. When interest rates fall, those that can refinance at a lower rate will do so. This is something that is good for home owners, however, it isn’t necessarily a good thing 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 be negative for 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 are highly vulnerable to interest rate shocks.