Prepayments 2019: Turnover, cash-out refinancing and new loan limits
admin | November 30, 2018
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Investors in agency MBS in 2019 will need to be even more focused on discount prepayment speeds. MBS began 2018 with roughly 20% of the market refinanceable and ended with only 5%, the lowest share since 2008. The pace on discounts should remain quite strong, although probably a bit slower than in 2018 since higher rates should slow home price appreciation, housing turnover and cash-out refinancing. Seasoned discount MBS should outperform new production. On a separate front, higher conforming loan limits should erode the quality of TBA relative to specified pools.
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Purchase activity will remain strong for seasoned collateral
Current sentiment is that housing is weakening. Existing home sales (seasonally adjusted) have declined throughout the year and home price appreciation (HPA) has slowed, with prices even falling in certain areas. This suggests discount prepayment speeds should slow as well.
Any slowdown is more likely to affect new production pools than seasoned pools. Housing turnover and cash-out refinances are very sensitive to the amount of equity a borrower has in their home, and more seasoned loans have benefited from high HPA since 2012. Therefore these borrowers are likely to continue to turnover quickly. But newer loans—2018 and especially 2019 vintages—won’t accumulate equity as quickly if HPA is lower. Therefore seasoned discount MBS should look attractive relative to new production pools.
It is also worth noting that purchase issuance in 2018 was extremely high, and strong purchase production implies fast housing turnover. The first ten months of 2018 had the highest purchase volumes since 2003 when measured by balance, and since 2007 when measured by number of loans. Even if turnover were to slow substantially, discount speeds could still remain at historically high levels.
Cash-out refis may have bottomed out
Cash-out refinance volumes were very robust in 2015, 2016, and 2017, but dropped in 2018. It is important to realize that not all cash-out refinances are discount prepayments. A borrower might refinance to get a lower rate and take out cash at the same time; this loan is a cash-out refinance, not a rate/term refinance. So as rates increase many of these borrowers won’t refinance because they don’t want to do a refinance for cash alone.
From January to October 2018, rate/term refi production (at Freddie Mac) fell roughly 33% while cash-out volume was roughly unchanged. Cash-out refinances never dropped below $3.0 billion and have averaged $3.2 billion over the last four months, suggesting that many of these cash-out refinances are probably occurring in discount pools.
One way to estimate purchase and cash-out prepayment speeds is to assume that the proportion of purchase production to total production is equal to the ratio of purchase prepays to total prepays, and to do an equivalent calculation for cash-out refinances. This suggests that turnover speeds have been roughly 7.4 CPR and cash-out speeds roughly 1.3 CPR over the last four months. The worst case scenario, if cash-out refinances went to zero, is a 1.3 CPR slowdown.
Borrowers need to build equity in their homes in order to do a cash-out refinance. Lower HPA means that the 2019 vintage will take longer to build sufficient equity, meaning that seasoned vintages should maintain faster cash-out prepayment speeds. This is a benefit to seasoned MBS pools over new production.
Higher loan limits hurt generic 2019 pools
The FHFA announced on November 27 that base loan limits are increasing to $484,350 in 2019, an increase from $453,100 in 2018. This is a negative for the quality of generic 2019 pools, since loans that would have counted against the jumbo de minimis limit of 10% can now be pooled without constraint in TBA-eligible pools. Average loan sizes should move higher; they increased $10,000 from 2017 to 2018. Therefore pay-ups on specified pools should increase.
A similar pattern has played out in Ginnie Mae pools; as more originators become comfortable creating loan balance specified pools through the Ginnie Mae custom program, the quality of the remaining multi-issuer pool has deteriorated. This trend should continue in 2019. Higher loan limits could also increase the VA share of the multi pools, another potential negative for Ginnie Mae TBA.