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What do declining mortgage rates mean for refinancing activity?

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      By Alexander Payne, CFAPortfolio Manager, Global Income Group, Eaton Vance Management

      Boston - The average rate on a 30-year fixed rate mortgage has fallen to 3.73% from 4.51% at the start of the year. This has led to an uptick in mortgage refinancings and an even bigger increase in refi-related news coverage. It is true that prepayment rates have doubled during the period, but they did so from near the all-time low in refi activity and reached just 17 CPR in July (Conditional Prepayment Rate is the annualized % of borrowers who refinance each year). For some perspective, in August 2003 prepayment rates hit 54 CPR meaning that more Americans with a mortgage refinanced than didn't!

      Why won't 2019 be like 2003? Fewer borrowers have an incentive to refinance today because rates are less than 1% below the multi-year highs, but in 2003 mortgage rates had fallen by roughly 3.5%. More importantly, the average mortgage rate over the past 5 years was 3.99% so today's 3.73% isn't all that compelling. In 2003, the trailing 5 year average was 6.78% versus a cycle low of 4.90% meaning the average borrower had almost a 2 point incentive to refinance.

      AP1

      Source: Bloomberg ILM3NAVG Index (Bankrate.com US Home Mortgage 30 Year Fixed National Average. Rate includes only 30-year fixed mortgage products, with and without points. This index is the overnight national average.)

      How did agency mortgage-backed securities perform during the 2003 refi wave? The ICE BofAML US Mortgage Backed Securities Index returned +3.29% in 2003.

      Do all borrowers exhibit the same prepayment behavior? Mortgage characteristics such as loan size, servicer and geography, among others, can have a major impact on a borrower's sensitivity to changes in mortgage rates. For example, larger "jumbo" loans are much more likely to prepay when rates fall than ones with a smaller balance. This is largely due to the size of the fixed costs related to refinancing, which can approach $5,000. Generally, those fees are more easily absorbed by a borrower with a $500,000 mortgage than one with a $50,000 mortgage and are recouped much sooner. The jumbo borrower in this example breaks even in just 1 year for a 1% reduction in mortgage rate ($500,000 balance x 1% rate reduction = $5,000 annual savings) but the lower balance borrower wouldn't recoup this $5,000 expense for 10 years. There are also behavioral factors at play: jumbo borrowers are more likely to follow markets or have a financial advisor alert them to the possible savings.

      AP2

      Source: Riskspan, as of 8/23/19.

      Geography is another driver of prepayment rates. In the chart below we compare California and Oklahoma using loan sizes between $200,000 and $300,000 in order to compare apples:apples and avoid repeating our jumbo/small balance analysis from earlier. Over that past five years, the Oklahoma loans prepaid 3 CPR slower and the peak speed was more than 7 CPR slower. There are multiple drivers of this divergence: faster home price growth in California creates demand for cashout refis; greater job mobility leads to existing mortgages being prepaid before leaving for a new home; and a longer manual underwriting process for rural community banks than tech-based lenders that are more prevalent on the coasts.

      AP3

      Source: Riskspan, as of 8/23/19.

      Bottom line: Mortgage prepayments have increased but we are far from a "boom", and even in those elevated refi periods agency MBS returns were positive. Lower rates today mean that having an experienced team, able to sort through the all of the different mortgage pool characteristics to add value, is that much more important.