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Morningstar: Here’s the impact of rising interest rates on mortgage-backed securities

Prepayments will slow, default risk could rise

The latest data from Freddie Mac, released Thursday, showed that mortgage interest rates are on the rise again.

According to Freddie Mac’s latest report, the 30-year fixed-rate mortgage increased to 4.19% for the week ending Jan. 26, 2017, up from 4.09% in the previous week.

Overall, as shown in Freddie Mac’s report, interest rates have been on the rise since the election, buffeted by the December announcement from the Federal Open Market Committee that it planned to increase the federal funds rate for the first time in a year.

A recent report from Black Knight Financial Services showed the impact of rising interest rates on borrowers, with some 5 million borrowers losing the incentive to refinance as interest rates rose.

But what will the impact of rising interest rates be on mortgage-backed securities, especially private-label mortgages?

A new report from Morningstar suggests that between the Fed’s decision to raise rates and the indication that more rate increases are to come, prepayments will fall throughout 2017.

But as prepayments slow, default risk will increase, the report shows.

“In the benign U.S. interest-rate environment of recent years, the rapid pace of prepayments arguably has played a role in containing defaults,” Morningstar’s analysts write.

“Tighter mortgage underwriting, low loan-to-value requirements, and 100% due diligence in post-crisis jumbo residential mortgage-backed security transactions have limited defaults to only a handful of loans over the past seven years,” the report continues.

“Prepayments in post-crisis jumbo transactions have been over 20% within the first 12 months of loan origination,” the analysts add. “Rapid prepayments have accelerated the payments to bondholders, reducing bond duration. Rising interest rates could potentially cut prepayments to a fraction of the current levels and increase default risk in RMBS transactions.”

As Morningstar notes, prepayments are driven by interest rates. As interest rates rise, borrowers lose the incentive to refinance. For example, if the market interest rate is 4.19%, as it is now, a borrower with an interest rate of 3.75% has no incentive to refinance. And as refinances drop, so do prepayments.

Morningstar’s report states that it expects that mortgages with LTV ratios below 60% and interest rates under 6% will see the biggest drop in prepayments.

“By our estimate, the concentration of this rate-sensitive borrower is 2.5 times higher in the post-crisis transactions,” the report states. “Therefore, based on our analysis, we expect rising interest rates to cause a disproportionately greater reduction in prepayments for post-crisis originations that have a higher concentration of low interest rate, low LTV mortgages.”

Morningstar’s analysts state that they expect approximately $164.77 billion of private-label mortgages, which represents nearly a third of the non-agency universe, will likely see their prepayments cut in half if the rate refinancing incentives disappear.

While prepayments are expected to slow, the impact of rising interest rates on new private-label RMBS is a little murkier based on the regulatory uncertainty that exists in Washington, D.C. right now.

“The challenge facing the private-label RMBS market, specifically the high cost of securitization, remains largely unaddressed,” Morningstar notes. “Much will depend on the regulatory landscape under the Trump administration.”

And while President Trump recently said he wants to cut all regulation by 75%, how that looks in practice is still an unknown.

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