Rising Rates Will Cut Prepayments: Morningstar

Mortgage

Nearly a third of the loans in the nonagency space will likely see prepayments cut in half if refinancing incentives disappear due to higher interest rates, according Morningstar Credit Ratings.

Mortgages with interest rates below 6% and loan-to-value ratios under 60% are expected to display the largest drop in prepayments as a result of higher rates, Morningstar said in a note released Thursday. And because there is such a high concentration of loans that fall into that category among post-crisis originations, these loans will demonstrate a disproportionately greater reduction in prepayments than loans originated before the financial crisis.

“If mortgage rates rise above the existing interest rates on RMBS pools, we expect to see a reduction in principal prepayments because of a decrease in refinancing activity,” the authors of the Morningstar report, Gaurav Singhania and Olgay Cangur, wrote. “The borrowers would have no incentive to refinance under these circumstances.”

Singhania and Cangur found that when there was a 0.25% rate refinance incentive, borrowers with an LTV below 60% were 11 times more likely to prepay their mortgages than those with an LTV above 100%.

Additionally, the authors noted that nearly two-thirds of post-crisis originations have mark-to-market LTVs below 60% versus just a third of precrisis loans. That disparity trickles down into expectations for residential mortgage-backed securities.

“By our calculation, over 96% of the post-crisis RMBS originations have mortgage interest rates below 6% with a Morningstar mark-to-market LTV below 80%,” Singhania and Cangur wrote. “By contrast, only half of the precrisis population falls into this category.”

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