By the Numbers
This refi wave may not weaken TBA collateral
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.
In a typical refinance wave, TBA collateral quality suffers as fast prepaying loans dominate new production. But things may play out differently this time. The loan size gap between new purchase loans and the typical outstanding loan has climbed steadily since the pandemic, which should help suppress the loan size of refinance loans relative to new purchase loans. And credit scores are usually higher for refinance loans since low credit borrowers are less likely to prepay. But the gap between purchase credit scores and outstanding credit scores (although, the latter are frozen at loan origination) has also widened. So, relative to the loans already being placed in TBA pools, new refinance loans may not have lower convexity.
When home prices are increasing the average purchase loan should be larger than the typical refinance loan (Exhibit 1). Prior to the pandemic this gap slowly widened from roughly $20,000 to $40,000, but heavy home price appreciation during the pandemic has pushed this gap to over $100,000 this year. That means new refinance loans may tend to have smaller loan sizes than purchase loans. This would not harm, and maybe even improve, the quality of the TBA. Of course, the typical refinance will be larger than the typical outstanding loan, since larger loans are more likely to prepay, and some borrowers will do cash-out refinances. But those factors are unlikely to overcome the $100,000+ gap between existing loans and new purchase loans.
Exhibit 1. Purchase loan sizes are much higher than those of outstanding loans.
Source: Fannie Mae, Freddie Mac, Ginnie Mae, Santander US Capital Markets.
Furthermore, the distribution of loan sizes at different rate incentives is different than before the pandemic (Exhibit 2). The left-hand chart shows the average outstanding loan size by rate incentive for current agency 30-year loans. The right-hand side shows how things looked in January 2019 before the refinance wave that started later that year and accelerated during the pandemic. In today’s pools, balances fall sharply for loans that are out-of-the money, bottoming out at roughly 300 bp out-of-the-money. But in 2019, discount loans were typically larger. That means, if rates fall further, the volume of refinances will increase but the loans refinancing will skew smaller. The dashed lines indicate the average loan size of new purchase loans over the preceding six months.
Exhibit 2. Loan sizes fall as loans are farther out-of-the-money.
Source: Fannie Mae, Freddie Mac, Ginnie Mae, Santander US Capital Markets.
The gap between purchase and outstanding credit scores has also widened over the past few years (Exhibit 3). Prior to the pandemic, purchase credit scores tended to be lower than the average credit scores of outstanding loans. In that environment, a pickup in refinancing would increase credit scores for new production and lower TBA convexity. But the credit score gap has widened since 2022, which suggests that a pickup in refinance volume should have a smaller effect on TBA quality than before. While this is not a perfect comparison, since the agencies do not disclose updated credit scores on loans in mortgage-backed securities, it should be indicative of how the relative differences between purchase and refi credit scores will change over time.
Exhibit 3. Purchase credit scores have jumped compared to outstanding loans.
Source: Fannie Mae, Freddie Mac, Ginnie Mae, Santander US Capital Markets.
Credit scores tend to go down for out-of-the-money loans in 2024 (Exhibit 4). This is also different than before the pandemic, when credit scores tended to increase for out-of-the-money loans. If rates were to drop, expanding the pool of refinanceable loans, the average credit score of those loans will drop. This will help mute the effect of a pickup in refinances on collateral quality. But in 2019, credit scores trended higher for loans farther out-of-the-money—deeper rallies would pull in even higher credit borrowers and that would lower TBA convexity.
Exhibit 4. Credit scores tend to decrease fur loans currently out-of-the-money.
Source: Fannie Mae, Freddie Mac, Ginnie Mae, Santander US Capital Markets.
The gap between new purchase LTVs and the current LTVs on outstanding loans has also widened (Exhibit 5). However, unlike the changes to loan size and credit score, this would serve to hurt TBA quality since lower LTV loans have lower convexity. Some borrowers may choose to increase their loan-to-value ratio with a cash-out refinance, but on average an increase in refinance loans would lower the LTV scores of new generic pools. However, this is likely to have a smaller effect on convexity than the difference due to loan size, so on balance TBA convexity is likely to improve if rates drop further.
Exhibit 5. The LTV gap between purchase and outstanding loans has widened.
Source: Fannie Mae, Freddie Mac, Ginnie Mae, Santander US Capital Markets.
The LTV distribution vs. rate incentive is similar in 2024 compared to 2019 (Exhibit 6). So, if rates fall, the LTVs of new pools is likely to drop in a similar fashion to prior refinance waves. This contrasts to the results for loan size and credit score, which both have markedly different distributions in 2024 vs. 2019.
Exhibit 6. The LTV gap between purchase and outstanding loans has widened.
Source: Fannie Mae, Freddie Mac, Ginnie Mae, Santander US Capital Markets.
A refinance wave typically changes the nature of loans in TBA pools for the worse. For one thing, a borrower that has proven willing to refinance is more likely to refinance another time. But in today’s market, refinance loan sizes and credit scores may both be lower relative to new purchase loans, which could lessen the effect on TBA quality…and maybe even improve it.
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