Experts say that Fannie Mae's new guidelines - announced last week - on cash-out refinancings will have minimal impact on prepayments going forward.

The changes are based on internal research Fannie conducted, confirming that cash-out refinancings have higher default rates than other types of refinancings. The study found that defaults in cash-out refinancings in which the loan balance increases by more than 20% are three times more likely than refinancings where the balance increases by less than 3%. The GSE also found that high appraisals are more common in cash-outs.

"We wanted to make sure that we were pricing for the risk on these mortgages while maintaining the availability of cash-out refinancings to the market," said Alfred King, spokesperson from Fannie.

He added that the impact of these pricing changes to borrowers is minimal (on the order of an additional $3 a month on their monthly mortgage payments). He also said that Fannie also expanded the LTV eligibility, so now borrowers can do limited cash-out refinancings of up to 100%. "There are some very positive changes for consumers," said King.

The new rules state that starting Feb. 1, 2003, mortgages that are bought or pooled by Fannie that qualify as cash-outs - in that the borrower is exceeding 2% of the new refinance mortgage or $2000 - will be subject to a loan-level price adjustment if the new LTV is 70.01% to 85% (see chart on this page).

The upside of Fannie's decision is that lenders will be able to avert higher default rates going forward. However, this might have implications on the deteriorating economy because tighter lending standards usually slows the consumer's ability to spend.

Effect on prepayments

Prepayment analysts say these changes will cause only a small ripple on prepayment speeds.

"I think that from a prepayment perspective, it's a minor but not a non existent impact," said Art Frank, head of mortgage research at Nomura Securities.

He notes that the new policy costs one-half point more for cash-out refinancings with LTVs of 70.01% to 75% and one quarter point more for those with 75.01% to 85% LTVs, so the prepayment impact should be small.

Vintages such as 1998 to1999 6s are expected to prepay more slowly. Aside from the new Fannie policy making it a little bit more expensive to cash-out, these borrowers only have a marginal incentive to refinance.

"For 30-year 6s, where the refinancing incentive is only about 50 basis points, this change could modestly slow the 1998 to 1999 vintage relative to 2001 to 2002, but the impact does not seem likely to exceed two to three CPR. High premiums should not be affected," noted Frank.

Capacity issues

Glenn Boyd, a prepayment analyst from UBS Warburg, said that if there weren't the current capacity constraints, lenders would have been telling their customers to do a cash-out before the changes occur in February of next year, given that the Fannie Mae policy changes would make cashing out a little bit more expensive. This would have lead to a spate of increased cash-out refinancings.

"But with the bankers being so capacity constrained, it is unlikely that they will be able to do substantially more cash-out refis than they would have otherwise," said Boyd. "I don't think the new guidelines will have a substantial impact in the next couple of months. There may be a bit of an impact before year-end but it will have a lot to do with what happens with rates. If we sell off from here, then by the year-end, capacity constraints will have loosened a great deal. In that scenario, there might be an increased demand for cash-out refis, especially from marginally refinanceable or slightly out-of-the-money coupons."

Boyd added that in the longer-term, for MBS issued on or after February 2003, marginally refinanceable pools are likely to display slightly slower speeds, since cash-outs will be more expensive (by about a quarter point, for many borrowers).

Aside from these factors, in capacity-constrained situations, originators pay more attention to streamlined refinancings because they do not require appraisals, which can cause a bottleneck in the refinancing process. Analysts said that when originators are trying to be as efficient as possible, it makes more sense for them to concentrate on streamlined refinancings that can be processed quickly and let cash-out refis go behind in the queue.

Meanwhile, in related news, representatives from Freddie Mac said that they have also seen deterioration in the performance of cash-out refinance mortgages and they are carefully looking at the figures. However, they will not comment on whether there would be any changes in the firm's cash-out policy on the horizon.

Earlier, Freddie stated that 67% of the loans they purchased in the second quarter were cash-outs. The Mortgage Bankers Association (MBA) also reported that cash-out refis comprised roughly $60 billion of consumer spending in 2001.

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