In a bid to lure wary investors back to mortgage securities, Bank of America will offer fixed-rate loans with prepayment penalties next year. The loans will be securitized by Fannie Mae and eventually offered by Wall Street.
The penalties are intended to discourage consumers from refinancing their home loans for the first three years of the life of the loans. The penalties would equal 2% of 80% of the outstanding loan amount, or $1,600 on the typical loan of $100,000. To entice consumers, rates on these loans would be shaved by an eighth to a quarter of a percent.
High prepayments on mortgage-backed securities have driven investors away from that market and widened yields by over a quarter of a percent this year. Lenders hope that mortgage-backed securities with prepayment penalties will restore predictability to the performance of these securities and thus attract investors.
The penalties "are the greatest thing since sliced bread," said Claus Lund, senior vice president and head of mortgage asset management at Bank of America Mortgage. Prepayment speeds on adjustable-rate mortgages with the penalties "have slowed down to a third to a half of similar loans without prepayment penalties," Mr. Lund said.
Several portfolio lenders, including Bank of America, already offer adjustable-rate loans with prepayment penalties and hold these loans in their portfolios. But the bank's new fixed-rate product is one of the first attempts to impose prepayment penalties on fixed-rate mortgages.
Though the bank expects initially to invest in the loans itself, the new product is aimed ultimately at all investors.
Fannie Mae - the Federal National Mortgage Association - said it is also working on a number of similar securitizing deals with other lenders. Todd Hempstead, director of negotiated transactions at Fannie Mae, said lenders look upon prepayment penalties as hedges to their servicing assets.
In offering the new loans, Bank of America is making a double bet: first, that consumers will be willing to curtail their prepayment options in exchange for lower rates; second, that investors will be willing to pay a premium for securities backed by such loans - thus making up the yield the lender loses from the consumer.
The problem, experts said, is that both sides may want larger inducements than they can get.
"The consumer has the best deal in the world" right now, said Mark L. Korell, group president of lender and investor services, at Norwest Mortgage Corp., Des Moines. "Rates go down, they don't want a penalty to refinance. Rates go up, they sit tight with the fixed-rate loans."
"What you have to do is entice the consumer away from the good deal, and that means lowering the rates," Mr. Korell said.
Consumers typically want a break of a quarter to a half of a percent on loans with prepayment penalties, and investors have been reluctant to take that kind of a hit, he said.
At Morgan Stanley & Co., New York, managing director David R. Warren said investors would welcome prepayment penalties, but the penalties must be meaningful.
"The market would be extraordinarily receptive to something that would reduce the risk of prepayment," Mr. Warren said.
But "Wall Street's willingness to pay up for these mortgages will be exactly commensurate with the amount of risk that is reduced," he added.
Ideally, investors would like five- to seven-year prepayment penalties similar to those imposed on commercial mortgages, he said.
Mr. Lund said homeowners were unlikely to cotton to such stiff penalties. But as investors understand that the three-year penalties lead to lower prepayment rates, they will be willing to pay a premium, he said.
"Investors eventually will start understanding that these are really very good securities for their portfolios and they will start paying up for those securities," Mr. Lund said.
Mr. Korell of Norwest said if the product catches on, Norwest would definitely explore it.
Another large mortgage banker, Countrywide, said it was studying the product. A spokeswoman said the lender wants to offer consumers a discount of at least 0.25%, and is waiting to see if that can be worked out.
At Fannie Mae, Mr. Hempstead said the mortgage agency wants to be sure consumers are getting a fair shake. "Our biggest concern is that the consumer is offered a fully disclosed choice, that they receive an economic benefit in exchange for the penalty," Mr. Hempstead said.
