By the Numbers
Lower rates, but not enough for refinancing
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.
The risk of refinancing remains low in agency MBS despite a 30 bp drop in mortgage rates since the start of the year and a 100 bp drop from their peak last fall. Most mortgage-backed securities are still deep out-of-the money, so rates would need to fall much lower to trigger faster prepayments. Some of the appreciable number of loans originated with high interest rates in 2022 should start to refinance if mortgage rates approach 5%. But Treasury yields have jumped lately as the Fed convinced markets it plans to keep interest rates high. Mortgage rates should also move higher, lowering refinance risk.
Most borrowers have mortgages with note rates well below the current mortgage rate. Many people refinanced and bought homes during 2020 and 2021, taking advantage of record low mortgage rates. The Fed started buying MBS after the onset of the pandemic, helping drive mortgage rates lower. And demand for housing increased, pushing home prices higher. Roughly 59% of outstanding 30-year mortgages in Fannie Mae and Freddie Mac pools were originated in 2020 through 2021 at low interest rates and are deeply out-of-the-money to refinance.
Only about 1% of borrowers are at least 75 bp in-the-money to refinance at current mortgage rates (Exhibit 1). And even if mortgage rates fall 100 bp, only about 5% of mortgages would have significant incentive to refinance. A 75 bp spread is sufficient to cover origination fees and offer enough savings to make a refinance worthwhile for most borrowers. Even if mortgage rates fell to roughly 3.25% only 29% of loans would be in-the-money to refinance, and many of those borrowers passed up the opportunity to refinance during 2020 and 2021.
Exhibit 1: The percent of MBS at least 75 bp in-the-money to refinance in various interest rate environments.
Based on loans in 30-year pools that are eligible for TBA delivery. Prepayment speeds represent the annual average speed expected at that mortgage rate. The base turnover speed represents a typical housing market.
Source: Fannie Mae, Freddie Mac, Santander US Capital Markets
However, there is more prepayment risk in the 2022 vintage (Exhibit 2). At current mortgage rates—6.16% according to Freddie Mac’s most recent survey—roughly 4% of that vintage is in-the-money to refinance. But that increases to 22.4% if mortgage rates fall to 5% and to 38.1% if mortgage rates fall to 4.5%. The largest outstanding vintages are 2020 and 2021 and would require mortgage rates to fall below 2.5% to entice many borrowers to refinance.
Exhibit 2: Prepays could pickup on the 2022 vintage if mortgage rates fell to 5%
Table shows the percent of borrowers at least 75 bp in-the-money to refinance at the given primary mortgage rate. Vintages with less than $50 bn outstanding are not shown.
Source: Fannie Mae, Freddie Mac, Santander US Capital Markets
Loan officers will have a strong incentive to solicit refinances when possible since origination volumes are so low. Therefore, the higher coupon 2022 vintage pools could refinance more rapidly than normal if mortgage rates were to dip low enough.
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