When the yield on the benchmark 30-year bond plunged below 6% this month, the possibility of another refinancing boom suddenly seemed plausible.
Fixed mortgage rates also fell, toward 7%. Observers concluded that a surge in refinancing that started earlier this year would accelerate as more borrowers found they could cut monthly mortgage costs more than enough to offset new loan fees.
For many lenders, that would simply mean more loans and more profits. But as the refi boom of 1993 showed, refinancing means loan runoff and accounting problems for loan servicers, loss of market share for thrifts that specialize in adjustable rate loans, and big losses for investors in securities backed by mortgage-interest income.
The end of 1997 finds some players rubbing their hands with anticipation, and others-notably thrifts that used to specialize in adjustable rate loans, and loan servicers-with their fingers crossed, hoping new strategies have put them in a better position to absorb a repayment boom.
The recent rate decline has also created additional uncertainty for a new group of lenders, specialists in subprime credits, who have proved surprisingly vulnerable to prepayment risk, even without a refinance boom.
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Mortgage Banks
Major mortgage banks report that refinancing already accounts for nearly half their volume. And some say that another 25- to 50-basis-point rate decline could ignite a repeat of the 1993 situation, when refinancing accounted for two-thirds to three-quarters of volume.
Even if rates edge back up, as many economists expect (see story on page 25), refinancing could still be a big factor for mortgage banks in 1998. "In the worst-case scenario, rates will rise by 25 basis points, and that would still keep us in a refi 'boomlet' atmosphere." said David A. Lereah, chief economist for the Mortgage Bankers Association of America.
Some observers are predicting that origination volume could surpass the $1 trillion mark in 1998, up from about $850 billion in 1997, if interest rates continue to fall.
"We're primarily a loan producer so this is an ideal environment," said Steven F. Herbert, chief financial officer of Resource Bancshares Mortgage Group, Columbia, S.C.
Resource originated $9.7 billion of mortgages in the first 11 months of the year, but its servicing portfolio as of Nov. 30 was only $8.2 billion. For that reason, Resource does not have to worry as much as mega-servicers do about portfolio run-off and accounting risks associated with having large amounts of servicing rights on its balance sheet.
Ronn K. Lytle, chief executive officer of Capstead Mortgage Co., a real estate investment trust with a $48.3 billion servicing portfolio, said companies with large portfolios are hedging them with financial instruments that increase in value as rates fall.
Mr. Lytle said Capstead, which does not originate loans, is experiencing more servicing run-off than usual, but the company could still add new servicing to its portfolio.
"In my view you can still buy servicing cheaper than you can originate it," he said.
Mr. Lytle said originators may benefit from increased volume in the short term. But once rates move back up, they will have to lay off staff and face severance costs.
"I don't think you have much choice. If the volume is there, you have to add as many employees as it takes to process that volume," Mr. Herbert agreed.
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Thrifts
Not long ago, it was a given that when fixed-rate mortgages grew cheaper, borrowers deserted adjustables-and thrifts-in droves.
But with more thrifts looking like big mortgage banks, that is not as true anymore. Borrowers still like to lock in those low fixed rates-and some big thrifts are getting in on the action.
"We have a lot to win" from the refinance boom, said Fred B. Koons, chairman of Dime Bancorp's North American Mortgage Co.
Mr. Koons' assessment is based on simple mortgage math. North American's originations have run at $20 billion a year since its merger with Dime. It is very unlikely that prepayments from its $30 billion servicing portfolio would be anywhere near that figure.
But "a real traditional portfolio lender is going to be hurt," says Caren E. Mayer, analyst at NationsBanc Montgomery Securities. A flat yield curve means interest margins are smaller, demand for adjustable rate mortgages is lower, and prepayments are high.
Among thrifts, "there are definitely winners and losers" in this environment, Ms. Mayer said-and it is harder to sort out which is which.
Wall Street
Like mortgage lenders, investment banks stand to gain from refinancing because it means more business.
Increased origination leads to more securitization and more fees. But for investors in mortgage-backed securities, refinancing can mean loan principal is sometimes returned, and interest income on prepaid loans is lost altogether.
"At this mortgage rate level, approximately 50% of the securitized mortgage universe is exposed to significant refinance pressure," said Dale Westhoff, senior managing director of mortgage research at Bear, Stearns & Co. "In the first quarter, we expect close to $20 billion in dollar volume of refis to hit the market."
Increases in prepayment speeds, reflecting the beginning of refinancing activity, have been as high as 50% from October to November, with 8%-coupon securities registering the biggest increases, Mr. Westhoff said.
"We are approaching very dangerous levels," said Inna Koren, first vice president for fixed income research at Prudential Securities. She said that 30% of 30-year mortgage loans are "deeply in the money," at rates of 8% or higher-meaning that there is a strong incentive to refinance.
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Subprime Lenders
When subprime mortgage lenders started going public two years ago, one of their big selling points was prepayment immunity.
A less creditworthy borrower would rarely take advantage of a drop in rates, lenders argued, because their poor credit disqualified them from a bank loan. In addition, subprime borrowers tend to be less financially savvy, and therefore less likely to refinance into a lower rate loan once they are locked in.
What no one counted on was the increase in competition. Suddenly borrowers who had been shunned by banks for years were being courted on all sides by start-up finance companies.
Scrappy newcomers made a point of targeting established players' portfolios, to prove that they could compete.
Prices increased for correspondant and bulk volume-and money-hungry brokers and small lenders called up borrowers they already knew, and rolled them into new loans to collect new origination fees.
What's more, debt consolidation loans inherently encourage faster prepayments-a fact that no one seemed to realize until it happened. Borrowers who have paid off all their credit cards get higher credit scores and qualify for larger loans at lower rates. Some debt consolidation lenders may not be reporting their loans to credit rating agencies, which only exacerbates the problem.
The end result? The subprime industry already has a prepayment crisis on its hands. Several lenders have had to take massive charges in recent months to cover higher-than-expected prepayments.
Loans that pay off faster than expected hit this segment of the mortgage industry particularly hard, as most companies calculate their earnings using gain-on-sale accounting. The method requires that they make assumptions about future loan performance. If only one of those assumptions is off, earnings are significantly hurt.
Lenders now are focused on retaining portfolios. They are tacking on prepayment penalties, beefing up customer service, and requiring customers who want to refinance to call in first-all in hopes of keeping prepayments down.
