With cash-out refinancing currently sky high, analysts reported last week that lower credit quality borrowers are increasingly using them as a vehicle to consolidate other higher interest loans - not only increasing prepayment speeds across coupons but bolstering the popularity of affordability mortgages as well.
Art Frank, head of mortgage research at Nomura Securities, said that in terms of prepayments, cash outs have an impact on current- and slight-premium-coupon speeds, as these borrowers often use their new mortgage as a debt consolidation vehicle or as a way to gain extra cash for other needs, such as a college education or home improvements. Additionally, slight-premium borrowers could move into a loan with a slightly lower rate, providing an additional incentive.
Frank also noted that cash outs have been seen frequently in the subprime sector as many mortgage lenders are now promoting debt consolidation policies involving cash outs. He added that the surge in this type of refinancing is a product of strong home price appreciation as well as the market not currently being in a refinancing boom.
"We haven't been seeing rates as low as they were in 2003 and 2004," said Frank. This is an environment in which the percentage of cash outs usually goes up, explains Frank, when refinancing is not as robust.
In its most recent report, Bear Stearns analysts said that strong housing markets have bolstered cash-out refis, driving aggregate discount speeds 40% to 50% above historical norms. Senior Managing Director V.S. Srinivasan explained that while cash-out refinancing is occurring across the coupon stack, it is currently affecting discount speeds more than premiums. Many borrowers who are cashing out in premiums may have refinanced regardless, because they have an economic incentive to do so. By contrast, the ability to cash out is the only reason to refinance for discount coupon borrowers. Bear also noted that weaker credit borrowers are more apt to tap into their home equity through a cash-out refi, resulting in relatively higher speeds on pools backed by lower FICO, higher LTV or Ginnie Mae collateral.
The demand for cash-outs as well as robust home price appreciation has shifted originations from traditional amortizing mortgages to affordability products, Bear Stearns added.
Srinivasan said that historically, some of these borrowers may have chosen to tap the equity in their homes through a second lien. But if these same borrowers chose to refinance from 30-year 5% fixed rate to a 5/1 hybrid IO at 5%, they can cash-out equity and maintain the same monthly payment. For instance, a borrower with a $200,000 30-year 5% fixed mortgage with a monthly payment of $1,073.64, can increase his mortgage to $257,000 without increasing the monthly payment by refinancing into a 5% 5/1 hybrid IO. "It is this desire to tap the equity in the house without an increase in monthly payments that pushes borrowers to affordability products." Srinivasan, explained.
Freddie Mac reported rising cash-out refinance activity for 2Q05 last week, attributing the increase to lower-than-expected interest rates on 30-year mortgages. Deputy Chief Economist Amy Crews Cutts said that two factors spurred in the rush to cash-outs: sub 6% mortgage rates and borrowers rushing to get money for future expenses now while it is cheap, particularly in light of expected rate hikes.
Freddie expects 30-year fixed mortgage rates to increase through the end of the year, capping the year out at 6%, which is about a 25 basis points higher versus the second quarter average. This is expected to dampen cash-out refinancing activity next year, and plunge from this year's $162 billion to about $69 billion in 2006.
Crews Cutts said that with the expected home price deceleration, it would take more time for homeowners to build equity and once appreciation slows to the expected 5% to 10%, borrowers would likely make very different choices, instead tapping into their other investments such as 401K plans for their financial needs.
The estimated $100 billion taken out of consumer spending, could adversely impact the economy, Crews Cutts said, specially in light of current lackluster business investment and the potential for even higher oil prices. All these factors, Crews Cutts warned, could potentially lead to another recession.
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