As home price appreciation prompts borrowers to tap the equity in their homes, researchers are looking at the impact on prepayments, now that rates may no longer be the primary incentive. MBS analysts from both Countrywide Securities and UBS delved into this issue last week, with very different perspectives. Meanwhile, Freddie Mac stated in its First Quarter 2004 Refinance Review that cashout refinancings were steady over the quarter (see related story on p. 16).
In a recent report, Countrywide examined recent cashout behavior and its impact on at-the-money prepayment speeds. In particular, the firm examined whether cashout refinancings can keep fixed-rate prepayment speeds at current historically fast levels, attributable largely to the rise in home prices in the last couple of years.
Researchers looked at loans funded in March and April 2004 where the original mortgages were conforming fixed-rate 30-year vehicles. Cashouts made up a third of all refinancing transactions. More than half of the new loans were taken as fixed-rate conforming 30-years. ARMs (conforming and nonconforming) made up 30%.
Countrywide looked at the percentage of cashout refis by the rate of the original loan. The data implied that cashouts comprise a bigger part of total refinancings at lower rate levels. This was expected, as there is generally less incentive to take a no-cash refinancing when your rate is already low. They also noted that the percentage of ARMs is consistently higher for cashout loans than for rate-and-term refinancings, especially at lower note rate levels.
The money taken out in cashout deals is usually significant in terms of absolute dollars and as a percentage of the original loan size. The key to changes in prepayment behavior, however, is whether cashout borrowers are willing to accept a smaller rate savings compared to non-cashout borrowers. In examining this aspect, researchers noted that there is a perceptible rise in the proportion with a small or negative rate savings for loans where large amounts of cash were taken out of the property.
Countrywide believes that cashout activity is the reason for some incremental refinancing activity for loans with marginal refinancing incentives. However, loans with small rate savings and large cash takeout make up a relatively small portion of the overall population. The firm believes that the phenomenon driving at-the-money prepayment speeds is the fixed-to-ARM effect - the borrower's ability to lessen the rate is still the predominant driver of these transactions and the cash that is being taken out is coincidental to the transaction, especially for those at the margins. Borrowers who are already in the money will likely refinance anyway whether or not tapping home equity is a concern, while borrowers with a zero or negative incentive can tap their equity through the vehicle of a second lien mortgage.
The impact of cashout refinancings for loans with a marginal refinancing incentive may impact prepayment speeds based on regional differences in real estate appreciation. Prepay speeds may be impacted by this in seasoned cohorts, as accumulated real estate appreciation and subsequent growth in equity stimulates refinancing activity.
For a long-term rise in rates, particularly under a flat yield curve environment that pushes up the ARM rate, Countrywide believes that the impact of cashout activity will fade. In that environment, second liens will be more efficient, especially for fully out-of the- money loans, since there is no reason to refinance the entire loan at a higher rate when the cash can be taken out through a second lien. "Therefore, we expect the marginal impact of cashout activity to decline as rates rise, even if that rate increase is not accompanied by stagnating or declining home prices," analysts wrote.
Cashouts and discounts
In a separate report, UBS argued that at the forward and end cusps of significant refinancing waves, cashouts boost discount speeds. However, this jump in speeds usually disappears several months after the wave. "We've argued that cashout refis are the dominant force behind these hyped-up speeds, based on how refi response curves change shape going into and out of a wave," wrote analysts.
On the initial part and final edge of these waves, the analysts add that 0 to 50 basis points out-of-the money discounts speeds are more reactive by three to six CPR. Historically, speeds on modestly out-of-the-money loans slow down three to six months after a refi wave and eventually fall in line with the usual long-term refinancing response. This is why, analysts said, recent speeds on 2003 4.5s could not be used to determine turnover levels, and are not really good predictors of long-term discount speeds.
"Discount speeds should deflate as cashouts dissipate," analysts said. "However, a historically strong housing market suggests robust speeds even in a 300 basis points sell-off."
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