A main driver of upward interest rate movement and volatility in 2022 has been the fear that the Fed may drain too much liquidity from the financial system. That wasn’t helped by the CPI figures released today that were higher than expected, meaning we could see a potentially more aggressive Fed response in the coming months. An additional concern for the mortgage industry is that rates will continue to rise as markets absorb normal securities issuance in addition to the Fed’s balance sheet run-off, which began on June 1. But will there be much run-off? At current lending rates, 99% of American homeowners have no incentive to refinance their mortgages.
In a plan outlined at the Fed’s May meeting, policymakers began winding down its $9 trillion balance sheet (which will further tighten credit for U.S. households) on June 1 at an initial combined monthly pace of $47.5 billion of Treasuries and agency MBS. The runoff rate is scheduled to increase to $95 billion by September which puts the Fed on track to reduce its balance sheet by about $3 trillion over the next three years. However, MBS paydowns in the Fed’s portfolio are estimated at only $30.5 billion, which is less than the final monthly cap of $35 billion. This would indicate a sort of self-feedback loop where the Fed actually has to sell because there isn’t enough run-off.
Let’s look at supply and run-off. The Fed has created demand destruction by increasing rates, and there is an argument it has also created supply destruction because there are millions of people locked into low rates. As we know, borrowers have the ability to “prepay” or pay off their mortgage early, creating prepayment risk for the bond holder. Prepayment risk is basically the risk that the MBS buyer will receive interest income on top of principal repayment for a shorter period of time than expected. Prepayment forces the MBS buyer to reinvest the principal, often at a lower rate of return. With the current 30-year conforming fixed rate just under 5.5%, there is zero refinance incentive for essentially the entire UMBS 30-year “universe.” One year ago, about 66% of the universe had incentive to refinance. Changes in interest rates certainly account for most prepayment risk (ask those who have refinanced their mortgage over the last couple of years), but interest rate changes alone can’t fully predict prepayment activity.
Prepayment speeds of mortgages have implications for all involved in the loan sale process. Prepayment data does pertain more to the investor community, but helps originators to understand the full picture of mortgage rates as it is a critical component of MBS and MSR valuation. Prepayment speeds help to indicate a loan’s future cash flow, which drives those MBS and MSR values. The ability of homeowners to prepay their mortgages presents a tricky pricing challenge in the bond market. While the backing of Fannie Mae, Freddie Mac, and Ginnie Mae effectively removes any credit risk, calculating prepayment risk is central to properly valuing MBS.
Prepayment data from May that was released this week showed Fannie 30-year prepayment speeds slowed 13%, following a 19% decline in the prior month. Fannie 15-year prepayments decreased 7% while Ginnie Mae II 30 speeds decreased by 16%. The decrease in speeds was driven by significantly higher rates, up 75 bps on a four-week lag. On that same lag, rates will again be higher by almost 50 bps for June’s prepayment data. Refinance demand continues to decline, with the May report marking slowing prepayment activity for the ninth month out of the last 12. Aggregate prepayment speeds slowed to 9.9 CPR, the slowest pace since April 2019. Net issuance declined to $42 billion in May from $100 billion in January, and gross issuance decreased to $142 billion from $165 billion in April and $237 billion in January.
With almost every American home owner having lost the incentive to refinance, this was no surprise. Refinancing demand, and thus prepayment speeds, should continue to slow. We will see what that means for the Fed’s balance sheet and supply. The highest CPR will remain within higher coupons of 2019 and older vintage where home price appreciation means lower LTVs and provides for potential cash out opportunities. Tappable equity is at a record-high, though the vast majority of this equity is held by high-credit borrowers with very low rates. There is also hope that we will see some increases in prepayment activity from the peak turnover of a spring and summer home buying season. Lenders do have a smaller universe of borrowers to work with, which will continue to be reflected in speeds, but lenders are focused on their respective niches, adding new products, and improving origination practices. With so much of the mortgage universe trading at a discount, it helps to work with servicers keeping speeds in those discounts fastest and cash in your pocket. Reach out to our MSR team, who offers a wealth of experience and suite of tools to help you with all your mortgage servicing rights needs.
*note: this commentary will return on June 24, 2022.
