- Structural changes taking place over many years in U.S. mortgage finance, along with the massive rate rally since the end of 2018, led in part to 2019’s refinancing wave.
- In 2019, steeper prepayment risk tiering increased the complexity of modeling and the need for more advanced analytical techniques.
- We identified three potential prepayment themes for 2020: Refinancing burnout could set in; payup value of collateral with call protection may erode; and a further rate rally could lead to an even stronger refinance wave.
Since the turn of the millennium, U.S. mortgage finance experienced a boom-bust-recovery housing cycle and underwent numerous structural changes. These changes led in part to a series of regime changes such as the 2019 refinancing wave, which was amplified by the 140-basis-point (bp) rate rally since the end of 2018. Looking back at 2019 and drawing on MSCI’s agency-MBS prepayment model, we look at potential prepayment themes for 2020.1
Regime changes mark the 21st century (so far) in MBS prepayment
The refinance incentive was calculated by subtracting the prevailing Freddie Mac 30-year survey rate from the weighted average gross rate of all outstanding Fannie Mae 30-year mortgages. Source: Recursion, MSCI.
As shown in the exhibit above, the past two decades of prepayment history can be divided into six regimes:
- 2000-2001: The conditional prepayment rate (CPR) line was in sync with the incentive line, which was below 50 bps. This period of time has often been regarded as benchmark years for refinance efficiency.
- 2002-2004: The CPR line soared above the incentive line, indicating extraordinarily efficient exercise of prepayment options for borrowers.
- 2005-2007: Aggregate incentive dropped below 50 bps, with the two lines mostly overlapping. The prepayment during this period was dominated by base prepayment speeds.
- 2008-2013: During the end of the financial crisis and in its aftermath, the prepayment line was substantially lower than the incentive line (which mostly stayed above 100 bps), due in part to tighter underwriting standards. The period witnessed unconventional policymaking, such as quantitative easing and the Home Affordable Refinance Program (HARP).
- 2014-2018: After years of refinance burnout — with lowered borrower participation in HARP and the downward drift of the weighted-average gross coupon (WAC) — prepayment decreased significantly in this period, especially as quantitative easing turned to tightening in 2017. Nevertheless, the prepayment line mostly remained below the incentive line.
- 2019: The gap between the prepayment and incentive lines narrowed meaningfully, indicating higher refinancing efficiency.
The refi waves of 2019 and 2016 — similar but different
Prepayment risk tiering was steeper in 2019 than in 2016. Typical call protection such as lower loan balance kept CPR low in both 2016 and 2019, while higher loan-balance collaterals clearly showed stronger refinance propensity in 2019. Further up in the risk tiering, the broker-origination channel offered a lower effective mortgage rate, perhaps due to nonbank originators’ aggressive push into mortgage brokering. Even with the 10-year Treasury rate at a similarly low level in 2019 as in 2016, higher demand for call protection in 2019, induced by a more severe refinance scare, drove spec payup — or the premium investors pay for specifying the call protection — significantly higher than in 2016.
Steeper prepayment risk tiering led to higher call-protection payup in 2019
Low loan balance (LLB) is defined by loan size of less than $85,000. For CPR comparison on the left: The refinance incentive was controlled between 100 and 150 bps; loan age was controlled between six and 24 months. Source: Recursion, MSCI.
Digital mortgage underwriting and appraisal waivers have most likely increased refinance efficiency in recent years.2 The property-inspection waiver (PIW) has steepened the loan-size prepayment curve. This was in line with the MSCI agency prepayment model’s assumption that prepayment propensity would generally increase due to technology advancement and credit expansion in recent years.
MSCI agency prepayment model anticipated higher refinance propensity in 2019
Source: MSCI Agency Fixed Rate Prepayment Model.
Over the next year, we may be able to observe whether we are entering a new prepayment regime and potentially reverting to an environment similar to the benchmark years of 2000-2001. We are still far from the 2003 refinancing craze. Additionally, improving refinance efficiency, combined with more detailed data disclosure from the agencies, has demanded more advanced surveillance technique to ensure diagnosis in depth.
Rank-based prepayment error tracking3 provided more advanced prepayment surveillance
Based on the MSCI agency prepayment model, the following observations may be made:
- In 2020, if rates stay range-bound — e.g., +/- 40 bps — refinance burnout may start to kick in, with the caveat that further underwriting efficiency could offset the burnout. The model provided some conditional and initial information that certain cohorts (e.g., 4s 2018) might have already shown signs of burnout in November, when the slowdown exceeded the implied change due to seasonality, day count and rate changes.
- Payup value of collateral with call protection may erode (i.e., a lower FICO score or lower loan balance), as mortgage originators broaden their refinance solicitation. The limited origination capacity was demonstrated by primary-secondary spread widening. As the proportion of more reactive and profitable borrowers shrink, originators may ramp up their efforts targeting the slower-prepayment subset of the mortgage universe.
- If rates rally in 2020, it may result in an additional refinancing trend — especially among the 2019 vintage of mortgages, which constitute the cheapest-to-deliver subset, with a high share of refinance loans, as well as of loans originated through brokers and with PIW eligibility and higher loan balances.
A brief review of prepayment in 2019 — in the context of the past two decades of U.S. prepayment history — might provide investors with context for further analysis. We used the MSCI Agency Fixed Rate Prepayment model to run 2020 prepayment forecasts for major Fannie Mae 30-year mortgage cohorts, assuming a base mortgage-rate scenario of 3.70%. The summary table below shows these baseline prepayment forecasts under these parameters, as we begin a new decade.
2020 MSCI prepayment forecasts
Forecasts for major Fannie Mae 30-year cohorts with assumed mortgage rate of 3.70 and collateral attributes, as of the beginning of 2020. Source: MSCI Agency Fixed Rate Prepayment Model
The author thanks Joy Zhang and Stephen Baumgarten for their contribution to this blog post.
1This report may contain analysis of historical data, which may include hypothetical, backtested or simulated performance results. There are frequently material differences between backtested or simulated performance results and actual results subsequently achieved by any investment strategy. The analysis and observations in this report are limited solely to the period of the relevant historical data, backtest or simulation. Past performance — whether actual, backtested or simulated — is no indication or guarantee of future performance. None of the information or analysis herein is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision or asset allocation and should not be relied on as such.
2“Appraisal Waivers: Frequently Asked Questions.” Fannie Mae, Oct. 7, 2019.
3Zhang, D. 2019. “MSCI Rank-Based Error Tracking for Agency MBS Prepayment Models.” MSCI Model Insight. (Client access only.)