PLANO, Texas — Three major factors–interest rates, housing economics and seasoning–are expected to slow prepayments in the short term, a white paper published by Southwest Corporate concluded.
However, current yield and spread levels justify keeping them on the books, according to the report.
"With real estate loans growing to more than 50% of credit union loans outstanding, it is very important the credit union managers fully understand the cash flow elements of this type of lending," said Steven Houle, author of the white paper and Southwest institutional adviser.
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Refinancing is the most significant component of prepayments, Houle said, spurring 45% of all prepayments since 1998. The concept is simple: when prevailing market rates fall below the borrower's existing mortgage rate, homeowners refinance.
Because rates fell to historic lows a few years ago, Houle said it's unlikely refinancing will have the significant effect on prepayments it previously had.
"The average coupon rate on 30-year mortgages outstanding is about 6.25%, comparable to today's average market rate. So, there's no incentive to refinance in today's market. Rates would have to decline to 5.25% to 5.50% before the incentive would kick back in," he said.
Growing economies and a strong housing sector also fuel prepayments, but the opposite is true in today's slowing economy, Houle said.
"Looking forward, this component of prepays will be slow because of the number of homeowners unable to refinance or willing to move," he said. "Even though approximately 95% of all mortgage holders are current on their payments, a small percentage of homeowners do find themselves in negative equity positions or underwater relative to the potential sales price of their home. As a result, borrowers in a negative equity position face higher refinance costs, while borrowers whose homes are worth less than what they paid for them are slow to sell them because they don't want to realize a loss."
The age of a mortgage, or its seasoning, impacts prepayments because homeowners are less likely to refinance during the first few years of the loan. Because so many mortgages were originated recently, Houle said, prepayments won't be driven by seasoning either.
New rules approved by the Federal Reserve on July 14 will make the mortgage process more difficult for lenders and buyers, most likely making up for any increased activity that bans on prepayment penalties may bring.
Rate caps, income verification and secondary-market elements proposed will make it more difficult for marginally qualified borrowers to get mortgages, contributing further to the prepayment slowdown, Houle said.
"In the short-term, it's fair to assume mortgage prepayments are going to be slow because the main drivers aren't present," he said. "With current market rates in-line with recent origination coupons, there is little financial incentive for some borrowers to refinance. Moreover, a percentage of homeowners are not willing to move because the pull-back in home prices has affected their equity position."
Though credit unions could experience longer durations in their mortgage asset portfolios, current yield and spread levels justify holding them.
"Current 15- and 30-year fixed-rate mortgage rates are approximately 170 to 200 basis points over the 10-year U.S. Treasury bond during a time when the steepness in the curve between the two- and 10-year notes has increased from 90 basis points to 125 basis points," the report concluded.
The white paper also provided some lip service for out-of-vogue, mortgage-backed investments.
"Agency-issued planned amortization class and current-paying sequential structures are approximately 80 basis points higher than comparable term agency-issued bullets. This shows the relative value that mortgage assets bring in relation to other alternatives," it said.
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