Record low rates lead to refinancing surge

HBS Lending

As the eurozone crisis deepens and investors flock to the safety of US government debt, one corner of the American economy has been smiling. US households, who qualify for mortgages backed by government agencies Fannie Mae and Freddie Mac, are taking advantage of record low interest rates to refinance home loans.

While the surge in “refis” could stimulate the economy if they lower household debt payments, for US banks it is divisive, benefiting the largest who issue most new mortgages, but hurting smaller rivals and investors who own the original loans, that are being repaid.

An unusual characteristic of the US market means lenders rarely keep mortgages on their books. Instead most home loans are sold into the secondary market, and repackaged into residential mortgage backed securities (RMBS).

The interest rate on 30-year fixed-rate mortgages has fallen by 24 basis points to a record low of 3.67 per cent this year. But the yield on the main index of RMBS backed by government agencies has fallen more, to a low of 2.52 per cent, as demand for safe securities has soared.

Since newly issued mortgages offer a relatively high yield compared with mortgage securities already in the market, they are in high demand, allowing banks who originate them to pocket a “gain on sale” to investors.

As a result mortgage revenue at large banks is soaring, up 85 per cent at Bank of America and 67 per cent at JPMorgan Chase in the first quarter of 2012 compared with the final quarter of 2011, even though actual lending fell at both banks.

That is expected to rise again this quarter thanks to a rush in refinancings under the government’s Home Affordable Refinance Programme (Harp), which Goldman Sachs analysts believe has accounted for up to 30 per cent of mortgage volume since April.

Harp mortgages are especially in demand from investors, as they are unlikely to be refinanced again at lower rates, since borrowers can only use the Harp facility once.

The flipside of the refinancing surge, however, is lower interest income and reinvestment risk for banks and investors holding the mortgages.

When homeowners refinance, the owner of the pre-existing mortgage is repaid the outstanding principal. If the loan was part of an RMBS, the principal is distributed to investors in proportion to their holdings.

“Prepayment is a double hit for mortgage owners and RMBS investors,” said Douglas Harter, a Credit Suisse analyst. “They not only lose future interest revenue, they are also saddled with cash, which they have to reinvest while yields are at record lows.”

The Mortgage Bankers Association expects $870bn in mortgage debt to be refinanced this year. That would represent an annual loss of almost $9bn in interest revenue alone, assuming the average refinancing lowers the borrowing rate by 1 percentage point.

Those losses are not distributed evenly.

According to Nomura, 23 large US banks write 75 per cent of mortgages, but own just 20 per cent of the assets, meaning they benefit disproportionately from higher gains on sale, and suffer little from lost interest revenue, and reinvestment risk.

By far the hardest hit are “thrifts”, which deal almost exclusively in deposit taking and mortgage lending, and, unlike large banks, keep most mortgages on their books.

Ninety-four per cent of all assets at New Jersey’s Hudson City Bancorp are residential mortgages or RMBS, according to SNL financial data. At Capitol Federal in Kansas and New York based Astoria Federal the numbers are 80 per cent and 76 per cent respectively.

“For thrifts refis are the single biggest headwind,” said Collyn Gilbert, a bank analyst at Stifel Nicolaus.

Ms Gilbert estimates that thrifts could see up to 20 per cent of their assets refinanced this year, “materially” eroding net interest margins. Some are also unwilling to reinvest the principal from repaid mortgages.

Individual investors will also suffer.

Foreign and domestic investors own approximately 40 per cent of US mortgage debt, mainly through fixed-income mutual funds, significantly more than domestic banks.

“You could characterise this as a transfer, from American and foreign fixed-income investors to the large banks,” said Brian Foran at Nomura.

By Ajay Makan in New York

Additional reporting by Tracy Alloway

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