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Clocking the pace of prepayments.

By monitoring title search activity around the country, a database can provide very accurate predictions of when prepayments are likely to run at top speeds.

THE TREMENDOUS surge in mortgage prepayments that occurred during the past few months, as interest rates dipped well into single digits, was a tremendous boon to mortgage originators, title insurance companies and others on the production side of the business.

But not everyone in the mortgage industry was treated so well by this prepayment rush. In particular, mortgage servicers and investors in premium mortgages or mortgage-backed securities were less than enthusiastic about the prepayment surge that devoured higher-coupon mortgage assets. Had they been able to see the dimensions of the refinancing boom that was coming, it might well have allowed them time to prepare for the onslaught of prepayments and, in some way, limit the damage to their assets.

Telerate's Advance Factor Service (AFS) was developed to provide participants in the mortgage market with accurate information about the future direction of prepayments over any coming three-month period. To produce its unusually precise estimates, AFS relies upon proprietary, fundamental data. The premise behind the AFS estimates is that the placement of a title search order on a property is a leading indicator that the mortgage on that property is likely to prepay in the next few months.

Title searches are a requirement of origination and not an exercise that one would go through for any reason other than as a step in the process to refinance or obtain a purchase mortgage on a residence. Thus, the fact that a title search is being done is an extremely reliable indicator of a loan prepayment.

Telerate's Mortgage Securities Division, which produces AFS, is currently in the process of developing additional proprietary sources of information that will help identify even more precisely, which homebuyers are likely to sell their houses or refinance their mortgages. This article will discuss how these new developments will lead to more accurate estimates of prepayments. Knowing for certain that a huge payoff surge is in the works, and isolating the segments of the market where it will hit the hardest, should help servicers and investors in premium coupon MBS to see these developments coming in the future.

Interest rates and refinancings

Most analysts have focused on the impact that lower interest rates have on the incentive of homeowners to refinance their mortgages. Such analysis comes up with a probability of prepayment that depends upon the difference between the present value of the expected savings from the lower mortgage rates and the total cost of refinancing (application fee, appraisal, title search, points, and so forth.) The expected result is that the bigger the net savings, the greater the likelihood that a homeowner will refinance. A rule of thumb emerged from this analysis that a homeowner who expects to stay in his or her house for three years needs a 2 percentage point drop in interest rates to make refinancing worthwhile; if the horizon is shorter, a bigger drop is needed and a smaller drop for longer horizon.

Chart 1 shows prepayments of Fannie Mae securities by coupon rate and illustrates this behavior. In September, 11 percent securities (with mortgages rates 11.5 percent to 12 percent) had the fastest prepayment speeds. As mortgage rates dropped over the next four months, so did the coupon rate exhibiting the most rapid prepayments to 10.5 percent securities in November and 10 percent securities in January.

Influences on the refinancing decision

Despite the drop in rates and the resulting high prepayment speeds, still more than half of the holders of 10.5 percent to 11 percent mortgages have not yet refinanced their mortgages (the total number of loans in this category is approximately six million loans). And upwards of 20 percent of homeowners with mortgage rates above 12 percent have not yet refinanced. Clearly, there are factors other than interest rates at work that affect the refinancing decision.

Some analysts have called these homeowners "ostriches," implying either that they are unaware that they can refinance their mortgage or that they cannot do the cost-benefit calculation. However, with the number of stories in the mass media about refinancing, such explanations seem far-fetched indeed.

On an individual basis, the recession undoubtedly has taken its toll on some candidates for refinancing. For example, homeowners who are either without work or whose new jobs pay less than their old jobs have likely been hurt. Or even if someone's new job is of equal pay, a spell of unemployment may have left a damaged credit report unacceptable to a prospective lender, as might a divorce. But admittedly the number of people who have been laid off or divorced is still a small percentage of homeowners who might be considered prime candidates for refinancing. Even if they all happened to hold mortgages with rates above 10 percent, they would still constitute only a small proportion of refinance candidates who have elected so far not to refinance, even though the interest rate differential is substantial.

Impact of declining house prices

To better explain the behavior of homeowners who have not yet refinanced requires us to identify phenomena that are broader in scope than the relatively isolated circumstances of unemployment or divorce. One such phenomenon is declining or stagnating property values.

Underwriting guidelines set by Freddie Mac and Fannie Mae generally require a 20 percent equity down payment in a purchase/sale transaction (or less with the addition of private mortgage insurance, which drives up the monthly payment) or that there be at least 20 percent equity - defined as current market value less the mortgage amount - in the house for a refinance. Some would-be purchasers may be kept out of the market until they can accumulate sufficient cash to make the required down payment, especially first-time buyers. However, most analyses of refinancing behavior, however, ignore the equity issue, perhaps because the refinancing surge in 1986 and 1987 came during a period of sharply rising housing prices that systematically increased homeowners' equity in many markets.

Since 1987, however, average house prices have increased only about 3 percent per year. But this average masks an important trend. Prices rose about 6 percent per year during 1987 to 1989 but dropped nearly 2 percent per year in 1990 and 1991. Segmenting the country into regions and price categories shows that there is tremendous volatility within these national averages. For example, in the Northeast, prices rose about 1 percent per year on average. However, this performance was buoyed by steady gains in prices for houses costing under $100,000, while prices for houses costing more than $200,000 dropped some 15 percent from their peak. In Boston, there has been a cumulative 10 percent drop since 1987 for all houses, and those who bought more expensive houses or who bought at the peak experienced declines of more than 20 percent.

In contrast, the Midwest saw steady gains of about 2 percent per year for all but the most expensive houses, which only declined 1 percent during 1991. And in cities such as Chicago, which saw average price gains of twice the Midwest average, prices of even the most expensive houses didn't decline at all.

Not so coincidentally, mortgage rates peaked at about the same time prices did in 1989 in the 10.5 to 11 percent range. Homebuyers who bought at the price peak in 1989 would be candidates for refinancing at current interest rate levels. But 25 percent of the housing stock is located in areas of the country that have experienced price declines of more than 10 percent since 1989. Of the four million buyers of homes in 1989, possibly as many as one million are prevented from refinancing because they have seen their equity erode to the point where refinancing is not possible. These homeowners account for as much as 50 percent of those who have not yet refinanced their homes.

These differences in housing price movements mirror exactly what has happened to mortgage prepayments on a regional level. Mortgage level detail from Freddie Mac that is available through Telerate's Mortgage Securities Division shows that prepayment speeds on 10.5 to 11 percent mortgages in the Midwest over the past year have been twice the prepayment rates on similar mortgages from the Northeast, where depreciation has eroded equity to the point where some refinancing is not feasible.

Impact of housing turnover

Economic theory suggests that there is a basic relationship between supply, demand and price. Some observers thought that economic theory had been stood on its head during the go-go years of the late 1970s and 1980s when housing prices soared. But Chart 2 suggest that these "laws" still operate. Unit sales of houses in the South and Midwest declined more sharply over the past year relative to the Northeast and West. Sales on both coasts were relatively buoyant but only at the cost of greater declines in price.

This pattern is consistent with economic conditions throughout the country. The Northeast and West are more reliant on financial services and related industries, which have been hit hard in the past few years. Thus, many of the transactions that occurred in these regions may have been forced sales at discounted prices by job losers, whereas sellers in the Midwest and South have been able to be more patient on average, perhaps waiting longer to sell their houses but not discounting prices so significantly.

Implications for refinancing and

sale activity

Conventional wisdom maintains that the cycle in refinancings is either over or will soon be over. Past refinancing cycles in early 1986 and early 1987 each lasted about six months and were brought to an end by rising mortgage rates. In the most recent refinancing cycle, prepayment speeds started rising in October 1991 and mortgage rates have risen 5/8 percent since mid-January, so that if the current cycle is similar to the two previous cycles, conditions are right for prepayment speeds to peak in March.

In the short run, AFS's data on title search order activity tends to confirm this view. Orders peaked in the last week of January; given the normal two to three month lead time to closings, AFS estimates that prepayment speeds probably will peak in March and certainly no later than April.

The longer term view is less certain, however. The economy in general and the housing market in particular is showing some signs of life. For example, sales of new homes jumped 13 percent in January, almost entirely on the strength of activity in the Midwest. This surge in activity may be an early indicator that midwestern homeowners looking to sell their homes will be a bit more flexible with respect to prices and that sales will pick up. Moreover, in the Northeast and California, there are some signs that prices are beginning to rise, especially for the higher-priced houses that were hit the hardest during the past two years.

If these price and sales trends do emerge, then there could be a renewed surge in refinancings even at current levels of interest rates. Given the recent increases in mortgage rates, it is likely that the affected security coupons will be a bit higher, retracing the pattern in Chart 1 back from January to November. And if mortgage rates subsequently fall again, they will only serve to unlock more of the pent-up demand for refinancings that has been delayed because of the previous pattern of price and sales declines.

Further research on new products

The application of housing price data to prepayment analysis is in the ascent stage of integrating more fully a broad range of data from the real estate market. For example, Telerate is constructing housing price indexes for many specific segments of the market, such as condominium units in the Wilshire corridor in Los Angeles, and it will soon be possible to analyze price change by physical attributes as well as location, (i.e., all three bedroom, two bath houses on a half-acre lot). Such detailed analysis is the first step toward "automated appraisals" that servicers could use to monitor the likelihood of delinquencies and defaults.

This discussion has focused on the impact that declines in housing equity have in slowing refinancings. But there is a second, potentially more serious impact from home price erosion: as equity becomes negative, homeowners will become increasingly more likely to become delinquent or default on their mortgage. While higher defaults increase prepayments as do refinancings, the impact on the value of a servicing portfolio is much more serious. Chart 3 summarizes the impact that changes in house prices have on equity/loan-to-value ratios and refinancings/defaults. Specifying this relationship is the first step in a more complete model of credit analysis for the mortgage market. The second step is quantifying the impact of declining housing equity on delinquencies and defaults.

This kind of "macro" market risk analysis is a natural complement to the more normal "micro" credit report-based risk analysis that lenders routinely perform. Telerate is working to combine both kinds of analysis into a single framework. We believe this framework will be especially useful for analysis of private pass-through securities issued by conduits such as Greenwich Capital Associates, Residential Funding Corporation and the RTC.

Gordon Monsen is president and Douglas Bendt is vice president of Telerate's Mortgage Securities Division, a subsidiary of Dow Jones, located in Jersey City, New Jersey.




The price indexes used in this article are calculated by Telerate's Mortgage Securities Division using a weighted repeat-sales method. This method calculates the average monthly percent change in the price of a house between its current sale and its previous sale.

To arrive at a monthly or annual number, this monthly percent change is averaged over all houses sold during that period.

In contrast to most other measures of housing price change that compare the change in the median price of all houses sold in two periods, the repeat sales approach controls for two of the major determinants of value - the physical location of the house and its characteristics or quality.

Telerate gathers sales price data on every transaction in more than 400 counties across the United States, mostly in urban areas. Last year, these areas accounted for nearly 1.5 million transactions, or about 40 percent of all purchases/sales.
COPYRIGHT 1992 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Title Annotation:monitoring prepayments with the use of a computer database
Author:Monsen, Gordon; Bendt, Douglas
Publication:Mortgage Banking
Date:Apr 1, 1992
Previous Article:A peak year for private pass-throughs.
Next Article:Refimania.

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