Real Estate

How the refinancing boom could hit banks, investors

Mortgage rates on their way down again?
Mortgage rates on their way down again?

The average U.S. home may be roughly 5,000 miles from central London, but the recent Brexit vote is having a dramatic effect on mortgages from Maine to California and the banks and investors that back them. The average contract interest rate on the popular 30-year fixed home loan is approaching its record low, and that has created yet another refinance boom.

Even though interest rates have been low for several years, millions of homeowners have recently gained considerable home equity, thanks to fast-rising home prices.

They are now not only eligible for refinances but may want to tap some of that new-found equity. The mortgage market could have a refinance boom rivaling the one seen from 2008 to 2014, when about 25 million borrowers refinanced their mortgages, according to a new report from the Urban Institute authored by Jim Parrott and Alanna McCargo. That will mean short-term pain for some of the nation's largest mortgage servicers as well as investors in mortgage-backed securities, or MBS.

A sign advertising home mortgage services at a Bank of America branch in Manhattan Beach, Calif.
Patrick T. Fallon | Bloomberg | Getty Images

The surge in refinancing will increase prepay speeds for the securities backed by these mortgages, shortening the term of the investment and reducing the return. This will drive losses for investors with unhedged MBS positions. Similarly, servicers will see the revenue streams from their mortgage servicing rights, or MSRs, dry up as borrowers refinance out of the loans they are servicing. Those servicers that have not hedged these revenue streams and are unable to mitigate their losses with new MSRs will also see significant losses.

"It's the insurance companies and other entities that own the securities that really get hurt," noted Paul Miller, an analyst at FBR Capital Markets. "The banks will profit from it. Nonbanks are a bigger part of the originations today, but they still end up going through the big banks."

The one area in which lenders lose is in servicing the mortgages. When people refinance, the servicers often change.

The yield on the 10-year Treasury, which mortgage rates loosely follow, will have to stay low for a while, however, before mortgage rates move significantly lower, as there are more costs involved today for lenders than there were even four years ago. That is thanks to new federal regulations on lending.

"What guys are probably doing in the mortgage world is not really ramping up and seeing where the volatility shakes out. If they stay at these levels, you will see rates drop to the 3 ¼ percent range which will signal a material change," added Miller.

For investors in mortgage-backed bonds, refinances, or so-called prepayments, mean they get their money back, but that's not necessarily a good thing.

"One of the challenges posed by prepayments is typically borrowers prepay when interest rates drop, then investors end up with a whole lot of cash in a lower-interest rate environment," said Parrott, who also points out a tricky problem involving accounting rules at Freddie Mac.

The government-sponsored enterprise guards against the risk of rising interest rates by hedging with positions that do well when rates rise and poorly when they fall.

"The problem is the way the accounting laws work, they only report the hedges, not the positions they're hedging against. So if you have a lot of movement, the way the rules work, it shows all of this gain or loss," explained Parrott. "The reason why we care is if there is enough movement, then Freddie could have to report a loss, and whether they have to borrow money from Treasury in a given quarter is driven by what they have to report from that quarter."

The drop in Treasury yields in the first quarter of this year caused Freddie mac to report accounting losses of $1.4 billion related to its hedging of interest rate risk, leading to overall losses of $354 million. Should yields now fall even further, the losses could be greater. The losses would be reported just before the presidential election.