Key REITs outlook: Why mortgage refinance applications rose 3.4%
The MBA Refinance Index picks itself up off the mat
The Refinance Index rose 3.4% (from 1,386 to 1,439) as the bond market rallied on weak economic data. Refinances had been dropping like a stone, as the people who have home equity have already refinanced and the ones left with high rates are underwater.
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The MBA reported that the share of refinance applications increased to 52%. 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.
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 (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.
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.