Mortgage Refinancing’s Future May Mean Models Overstate Returns

A return to looser Fannie Mae and Freddie Mac (FMCC) underwriting guidelines for homeowners refinancing outside of post-crisis programs will probably create lower returns on mortgage-backed securities than most investors expect, according to Credit Suisse Group AG.

A measure of relative yields on Fannie Mae’s 4 percent securities would narrow to 10 basis points from 18 if the companies resume streamlined refinancing starting in 2014 with easier rules such as less documentation, Credit Suisse analysts Mahesh Swaminathan, Qumber Hassan and Vikram Rao wrote in a report today.

Those rules “at some point” are likely to replace the looser guidelines targeted at borrowers with little or no home equity under the federal Home Affordable Refinance Program introduced in 2009 and refined last year. That would boost prepayments among a new set of homeowners and hamper returns, they wrote.

“Under this scenario, MBS valuations are richer than current metrics imply,” the New York-based analysts said.

The assessment shows the greater challenges that government-backed mortgage-bond investors and analysts are having in studying the value of the securities after a boom and bust in U.S. housing tightened credit, weakened consumers, roiled the lending industry and prompted government action. While agency mortgage bonds carry little default risk, returns on the securities, which have climbed to near-record prices, depend on how quickly the debt gets repaid.

Barclays Model

A change in September 2010 to Barclays Plc models that estimate the pace of prepayments caused that firm’s assessments of so-called option-adjusted spreads, a measure of how much the securities yield relative to Treasuries, to jump to 103 basis points from 66 basis points, or 0.66 percentage point, according to its index data.

Option-adjusted spreads, or OAS, capture projected average yields relative to benchmark rates over a range of potential future interest rates.

Prepayments from refinancing, home sales and defaults usually harm mortgage-bond investors who paid more than face value by returning their money faster at par and curbing interest. Fannie Mae (FNMA) 4 percent securities trade for more than 107 cents on the dollar, meaning an investor would lose 7 percent if all the underlying loans were paid off immediately, according to data compiled by Bloomberg.

Average prices in Bank of America Merrill Lynch’s Mortgage Master Index were 108.65 cents on the dollar yesterday, near the record 108.7 reached Aug. 2. Prices have climbed from a 2012 low of 107.2 cent in March.

Streamline Suspension

Fannie Mae suspended its traditional program for streamlined refinancings when introducing HARP in 2009, while Freddie Mac followed later, the Credit Suisse analysts wrote.

The government-supported companies “are likely to reintroduce” those programs “at some point in the future,” they said.

The effects of restarting traditional streamlined refinancing after HARP’s scheduled end in 2013 can be seen by comparing prepayment differences between the two companies’ securities during certain time periods, and those for high- quality borrowers before and after HARP began, they said.

HARP allows borrowers with less than 20 percent home equity to refinance without obtaining mortgage insurance or by rolling over existing policies, a primary difference with the companies’ standard streamline programs.

The damage to investors from a resumption of traditional programs would be mitigated by higher benchmark interest rates or further increases in the fees Fannie Mae and Freddie Mac charge for guaranteeing mortgage bonds, which usually increase new-loan rates and reduce refinancing incentives, they wrote.

With current interest rates, Fannie Mae’s 4 percent securities would return 1.18 percent over 16 months without its traditional streamline program and 0.88 percent with it, the analysts wrote. With a 50-basis-point jump in rates toward the end of the period, the figures would be 0.72 percent and 0.52 percent, they said.

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

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net

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