Refi Reality: How to Benefit from the End of the US Refinancing Wave

The Tradex Group Weekly Blog

April 29, 2013

By Richard Travia, Director of Research

Refi Reality:  How to Benefit from the End of the US Refinancing Wave

If there is one indisputable catalyst that has helped the U.S. economy since 2008, it is cheap money – and lots of it.  Ultra-low interest rates, unprecedented monetary easing and never before seen government implemented programs have kept yields on long-dated fixed income artificially low, making borrowing money as cheap as it’s ever been.

It’s clear that the efforts have paid off – the U.S. economy has been slowly gaining traction and consumer spending, one of the main engines of growth, has been steadily ticking up.  Equally important, the Federal Reserve’s quantitative easing efforts have helped spur mortgage refinancing activity, driving down home loan rates and encouraging borrowers to refinance their mortgages.

The refinancing boom has certainly been impressive.  Despite slow to recover home prices in many parts of the country and difficulties among consumers in obtaining additional credit, mortgage refinancing has been the vast majority of overall mortgage activity since 2009, according to the Mortgage Bankers Association.

Indeed, refinancing activity over the past three years has saved borrowers $46 billion in interest payments, according to Moody's Analytics – money that consumers have used to purchase goods and services that in turn have helped propel the economy.

What it has also propelled is prepayment activity.  Consumers have been able to refinance their interest rate from 6%+ to approximately 4%, in many cases regardless of the equity they own in their homes.  This has naturally reduced the interest portion of a homeowner’s monthly mortgage payment.  Government programs such as HARP (and HARP 2.0) have accelerated this trend by getting underwater borrowers lower mortgage rates. 

But cracks are starting to appear.

While volatile, both mortgage activity and refinancing activity have slowed in recent months, with refinancing activity dropping to its lowest share of total activity in 10 months in March.  Indeed, refinancing accounted for 75% of all mortgage applications, down from 85-90% only a few weeks earlier and the smallest share of total applications since May 2012.

What it all points to is the inevitable end of the greatest refinancing boom ever.  Whether because rates can’t or won’t go any lower or because the majority of U.S. homeowners have already moved to refinance and lock in new mortgages at lower rates, activity appears to be waning.

  

While higher interest rates may be bad news for new homeowners and potentially the broader economy, it’s good news for holders of IO mortgage derivatives contracts.  As the speed of prepayments (refinancing) decelerates, a larger amount of interest payments will flow through to the IO security, creating larger monthly cash-flows and eventually resulting in a rise in IO prices.  The number of homeowners who pay down their mortgages via a refinancing – and in turn do not generate any more interest payments on their original mortgage – will inevitably slow.

And, as the saying goes, what goes down must go up, meaning sooner or later bond yields, and by extension, mortgage rates will begin climbing again, further reducing the virtuous circle of refinancings and pre-payments.

The conclusion:  Being invested in IO derivatives, and getting paid while you wait for higher interest rates, is a great place to be.  At Tradex, we have seen extraordinary results over the years from IO mortgage derivatives and are ready to increase our allocation again.  Given that rates can’t go much lower and inevitably will go higher, we are patiently waiting for IO’s to appreciate both quickly and substantially.