uploads/2015/01/MBA-Refinance-Index2.png

An Old Headache Returns: Increased Prepayment Speeds Up

By

Updated

The Mortgage Bankers Association Refinance Index finally increases 

The Mortgage Bankers Association (or MBA) Refinance Index rose 66% from 1,349 to 2,245 as rates finally fell enough to allow refinances. Since mid-2013, refinances have been dropping like a stone as the people who have home equity have already refinanced and the ones left with high rates are underwater.

The MBA reported that the share of refinance applications increased to 70.5%. This bond market rally has caught many by surprise, but it could be a pleasant surprise for the originators, who have had a horrendous year. Slowing refinance activity was a negative for originators, including PennyMac Mortgage Investment Trust (PMT), Nationstar Mortgage Holdings Inc. (NSM), and Redwood Trust, Inc. (RWT).

Article continues below advertisement

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 mortgages early, without penalty, and when interest rates fall, those who can refinance at a lower rate do. This is good for homeowners. But 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, especially those with a large exposure to fixed-rate, government-guaranteed mortgages such as American Capital Agency Corp. (AGNC) and Annaly Capital Management, Inc. (NLY).

Investors who want to protect themselves from prepayment risk should focus on REITs that invest primarily in adjustable rate securities and include names such as Hatteras Financial (HTS) and MFA Financial (MFA). These are much less likely to refinance because after the initial fixed-rate period, they float according to LIBOR. This reduces the incentive to refinance. Investors should also look at VanEck Vectors Mortgage REIT ETF (MORT).

Advertisement

More From Market Realist