Refinancing Anxiety Pushes Protection Costs to Record: Mortgages

Photographer: Jacob Kepler/Bloomberg

Bonds guaranteed by taxpayer-supported Fannie Mae and Freddie Mac or U.S.-owned Ginnie Mae averaged 108.65 cents on the dollar on July 20, the peak since at least 1986, Bank of America Merrill Lynch index data show. Close

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Photographer: Jacob Kepler/Bloomberg

Bonds guaranteed by taxpayer-supported Fannie Mae and Freddie Mac or U.S.-owned Ginnie Mae averaged 108.65 cents on the dollar on July 20, the peak since at least 1986, Bank of America Merrill Lynch index data show.

A retiring couple in Hebron, Connecticut, that recently considered refinancing their roughly $70,000 home loan has never been more attractive to the $5.3 trillion market for government-backed mortgage bonds.

The homeowners, who were leaving jobs in insurance and as a municipal worker, contacted Norcom Mortgage after seeing new loan rates had fallen a percentage point below what they’re paying, according to Greg Radding, a manager of retail production at the firm. After Radding ran through the math of how little they would save each month and closing costs of about $3,000, they opted to keep their current loan.

Borrowers with small loans frequently make that decision, said Radding. “They often just don’t feel like they’re getting much bang for their buck; What’s 50 bucks? It’s just not worth it to them.”

Mortgage investors, anxious over the record prices of government-backed securities, are paying unprecedented extra amounts for the types of bonds considered the least likely to prepay quickly, such as those backed by loans of less than $85,000. Bondholders paying more than face value risk losses if enough homeowners take out new mortgages to repay their existing debt. The securities have risen even as refinancing soars, driven by expanded government programs and loan rates that have set all-time lows for six straight weeks.

Protection Costs

Average values for agency mortgage bonds reached almost 109 cents on the dollar this month, bolstered by a jump in so-called pay-ups. That’s the extra amount investors pay for specific bonds above prices in trading where they don’t know exactly which securities they’re buying. FTN Financial says the cost of the refinancing protection, which in some cases now exceeds 5 cents on the dollar, has “skyrocketed.”

“With just how high MBS prices are, it’s very, very difficult to buy generic pools because you’re so at risk,” said John Anzalone, head of structured securities portfolio management at Atlanta-based Invesco Ltd., which oversees about $650 billion. “The higher the premium at risk is, the more you should be willing to pay for protection.”

Bonds guaranteed by taxpayer-supported Fannie Mae and Freddie Mac or U.S.-owned Ginnie Mae averaged 108.65 cents on the dollar on July 20, the peak since at least 1986, Bank of America Merrill Lynch index data show.

The debt, which has fallen to 108.48, is up from 107.59 at the start of this year. Gains amid Europe’s debt crisis and speculation the Federal Reserve may expand its bond purchases to bolster the economy drove down the average rate on a typical 30- year mortgage to 3.49 percent last week, from 3.95 percent at the end of 2011, according to Freddie Mac data.

Refinancing Boom

The rally partly reflects bond buyers’ belief that the refinancing boom will be limited by obstacles ranging from lenders’ constrained capacity and tight standards to consumers’ frustrations with banks and weakened finances, with even generic securities reaching records.

Two-thirds of investors surveyed last week by JPMorgan Chase & Co. are “overweight” mortgage securities, or holding more than found in benchmark bond indexes. Almost 80 percent expect the Fed to buy more of the debt, with 57 percent forecasting an announcement at or before its September meeting, according to a July 27 report by the bank’s analysts.

Refinancing applications climbed to a three-year high last week that was more than 57 percent greater than this year’s low in March, according to a Mortgage Bankers Association index. Still, the pace remained 46 percent below a 2003 peak.

More Options

Karen Mayfield, the mortgage banking national sales manager at BNP Paribas SA’s San Francisco-based Bank of the West unit, says part of the reason more homeowners aren’t replacing their loans is they mistakenly think they can’t qualify amid depressed home prices and stories of lenders demanding more paperwork.

“There are more options available than people realize,” she said. “This may be an inconvenient experience compared to what it used to be in the past, but it’s going to be even more worth it, based on where rates are.”

Mortgage-bond investors are willing to pay the price for protection against homeowners joining the wave.

Securities carrying premiums include those only filled with the smallest loans, as well as debt taken out more than seven years ago or less than three months. Also in demand are ones tied to rental properties and loans made under a program for Fannie Mae and Freddie Mac borrowers with little or no home equity known as the Home Affordable Refinance Program, or HARP.

Boost Margins

Originators set aside these types of mortgages for specific bonds to boost their margins on sales. That’s something they’ve done much more in recent years as a result of the higher pay-ups being offered, sometimes selling 30 different flavors of bonds at the same time, said Walt Schmidt, a mortgage strategist in Chicago at FTN Financial, the brokerage unit of First Horizon National Corp.

Loans with low balances are considered less likely to be refinanced because the potential monthly savings are smaller and closing costs relatively higher, limiting the homeowner’s incentive.

While lenders can help make some borrowers interested in refinancing by rolling such costs as for appraisals, attorney fees, title work and credit reports into loan rates or balances, or find homeowners interested in shorter terms rather than lower payments, they’re exceptions to the rule, Radding of Avon, Connecticut-based Norcom said.

‘Policy Risk’

That kind of prepayment protection is especially valued in a world where investors face “policy risk,” or the threat of rule changes, said Qumber Hassan, a Credit Suisse Group AG analyst. After HARP adjustments this year urged by the Obama administration, lawmakers including Democratic Senators Robert Menendez of New Jersey and California’s Barbara Boxer are seeking legislation to further expand it. The government, which failed to address refinancing challenges created by Federal Housing Administration insurance-rate hikes when tweaking HARP, then targeted them with changes that took effect last month.

Pay-ups on Fannie Mae’s 4.5 percent bonds with 30-year mortgages of less than $85,000 have soared to a record 4.8 cents on the dollar from about 3.5 cents in early June and about 0.7 cent a year ago, according to Credit Suisse data.

That’s come as prices in the so-called To Be Announced, or TBA, market for similar generic mortgage securities rose to roughly 108 cents from about 107 cents early last month and less than 104 cents a year ago, according to data compiled by Bloomberg. TBA sales contracts can be filled with debt matching a range of characteristics.

Rates on loans backing Fannie Mae 4.5 securities average about 5 percent.

Prepayment Speeds

Recent prepayments show why investors are paying more.

Loans underlying a 4.5 percent Fannie Mae bond from 2009 with low balances prepaid at a rate that would erase 4 percent of the debt in a year over the past three months, Bloomberg data show. Aggregate speeds for 4.5 percent debt were 25.5 percent, and a TBA trade means risking something worse than the average.

“The difference between the best pools and worst pools are just massive,” with some borrowers locked out of the boom by a variety of issues and others quick to jump in, Invesco’s Anzalone said. At some point pay-ups for different types of bonds can become “too rich, and they’re richer than they’ve been, but certainly a lot of it makes sense.”

Bryan Whalen, co-head of mortgage bonds at TCW Group Inc., which manages about $130 billion, agreed, saying that “as a general theme it’s still too early to take the trade off.”

The rise in pay-ups has been the most notable among debt with the lowest rates, said Brad Scott, Bank of America Corp.’s head trader of pass-through agency mortgage securities.

Pay-Up Costs

Investors had been assuming that while those borrowers are among the most sophisticated and most likely to qualify easily, they’d only recently taken out their mortgages and didn’t have enough incentive to pick up the phone to refinance again soon, he said.

“All of a sudden” that’s changing with rates moving even lower and poised to potentially fall further, he said. Pay-ups on the types of highest-rate bonds that offer protection against borrowers tapping HARP aren’t gaining as much because many investors estimate the program’s use may be peaking, he added.

Fannie Mae’s 3.5 percent securities filled with loans exceeding borrowers’ property values by 25 percent or more carry pay-ups of about 1.4 cents, up from about 0.3 cent at the start of this month, according to Credit Suisse data. While borrowers with those loans qualified under HARP, it’s available only on loans from before May 2009, meaning they need a jump in property prices or rule changes to refinance again.

‘Momentum Trade’

While a “wide variance between the fast and slow payers” in the current environment means specified pools should be more in demand, the size of pay-ups has gotten too large for investors to get higher returns with them, FTN’s Schmidt said.

“It’s a momentum trade at this point,” he said, adding that bond buyers would be better off switching to securities backed by 20-year loans from 30-year debt.

Investors paying for prepayment protection risk underperforming if bond prices decline and rates increase, leaving even the most dangerous homeowners in certain cohorts with no reason to refinance, according to Credit Suisse’s Hassan.

“If we sell-off from here, the fall could be very steep,” he said.

Still, the greater demand for slow paying bonds may feed upon itself by increasing the odds of receiving bad securities as those become a greater share of what’s being traded, according to Schmidt and Anzalone.

“Your worst-to-deliver right now is pretty horrendous,” said Anzalone, referring to the bonds investors must assume they’ll get via generic, TBA trades.

To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net

To contact the editors responsible for this story: Rob Urban in New York at robprag@bloomberg.net; Alan Goldstein at agoldstein5@bloomberg.net

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