By the Numbers

Lower rates help, but most mortgages still can’t refi

Brian Landy, CFA | February 2, 2024

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. This material does not constitute research.

Mortgage rates lately have fallen to the lowest level since May 2023 yet are still too high for most borrowers to refinance. However, many recently originated loans are well in-the-money and borrowers should be considering refinancing. And lenders are likely to boost marketing efforts to capture that business. Since only 2.6% of borrowers are in-the-money, the effect on aggregate speeds should be small. But certain cohorts should see speeds jump. Lower rates could also unlock some housing turnover, as lower rates make homes more affordable and sellers a little less locked into their current loans. TBA trading volume and dollar roll trading both picked up in January and reached two-year highs, likely the result of lower rates and more origination activity.

Over the last year, higher coupons have consistently offered higher projected excess returns than lower coupons after hedging duration. And the base case returns are large enough that higher coupons should continue to outperform lower coupons if rate fall despite the lower convexity. Investors worried about prepayments can buy protection in higher coupons in the form of specified pools, but the specified pools should underperform TBA if rates hold steady. Investors that can tolerate the prepayment risk are probably better off in up-in-coupon TBA.

Refinancing should be limited to newer, higher coupon cohorts

Despite rates falling below the recent low levels in December, only 2.6% of loans are in-the-money to refinance (Exhibit 1). However, it is a case of the haves and have-nots. Almost every loan in the small 7.0% and 7.5% coupons is at least 75 bp in-the-money to refinance, and nearly two-thirds of the 6.5% coupon has crossed that threshold. But only a handful of loans in the 6.0% cohort may be able to refinance, and no loans below that. But only a 40 bp drop would push over half of that coupon in-the-money. The loans in the 7.0% and 7.5% cohorts are relatively low loan age—two months and three months, respectively—so it should take few months for speeds to fully ramp.

Exhibit 1. Refinancing should be primarily confined to 6.5%s and above.

Source: Fannie Mae, Freddie Mac, Santander US Capital Markets

Most of the loans that are refinanceable were originated in 2023 (Exhibit 2). About 22.5% of the 2023 vintage is in-the-money, compared to only 1.7% of the 2022 vintage and nothing in older vintages. Mortgage rates would need to fall to 4.5% to put some pre-Covid loans into refinanceable territory, and even those numbers are modest. Mortgage rates at that level would put most of the 2023 vintage and about one-third of the 2022 vintage in-the-money.

Exhibit 2. Most of the refinanceable loans were originated in 2023.

Source: Fannie Mae, Freddie Mac, Santander US Capital Markets

It follows that the cohorts with currently refinanceable loans are the 6.0% through 7.5% cohorts from 2023, and a couple cohorts from 2022 (Exhibit 3). The 2023 vintage tends to have higher gross WAC to net coupon spreads than the 2022 vintage, so is at a somewhat higher risk of refinancing. For example, at the current mortgage rate the 6.5%s 2023 are 66.9% in-the-money while the 6.5%s 2022 are 60.2% in-the-money. And at a 6% mortgage rate, the 5.5%s 2023 will be 9.4% in-the-money while the 2022 vintage won’t have any refinanceable loans.

Exhibit 3. Most large cohorts are far from refinanceable.

Table includes the 15 largest cohorts and the 6 most refinanceable cohorts (two cohorts overlap).
Source: Fannie Mae, Freddie Mac, Santander US Capital Markets

Mortgage trading activity picked up as rates fell

TBA trading volumes shifted higher in January, likely as a result of lower mortgage rates (Exhibit 4). On top of the increase that happened last fall, activity reached levels that last occurred in late 2021. That is also comparable to trading volume in the year before the pandemic.

Exhibit 4. TBA trading volume also ticked higher in January.

Source: Federal Reserve, Santander US Capital Markets

Lower mortgage rates may have contributed to a jump in dollar roll activity (Exhibit 5). This increase likely pushed several conventional rolls to turn special in January—first the 3.5% and 4.0% rolls, and more recently the 5.0% roll. Rolls have rarely traded special since the Fed stopped buying mortgage-backed securities and permitted runoff of their MBS portfolio. Banks also largely stepped away from the market alongside the Fed, and slowed purchases further after the failures of Silicon Valley Bank and Signature Bank last March.

Exhibit 5. Dollar roll activity picked up in January.

Source: Federal Reserve, Santander US Capital Markets

Brian Landy, CFA
brian.landy@santander.us
1 (646) 776-7795

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