In a time of historically low mortgage rates, prepayments are expected to be high. That hasn’t been the case. When economists at the Federal Reserve Bank of San Francisco (FRSBF) found that a model based on prepayment data from 2000 through 2009 predicted prepayment rates in Q110 to be twice as high as what they actually were, they concluded that more factors were at play than the simple price of the loan. In reality, tightened lending terms for some borrowers, weakening demand for housing and high foreclosure rates have more of an impact than previously thought. Mortgage borrowers have the option to prepay their loans, usually with a penalty, even if they do not intend to sell the home. When the home isn’t sold, prepayment is usually associated with refinancing the mortgage, according to a report from the FRBSF. The most obvious reason to refinance is to capitalize on lower interest rates and drive down monthly payments. Mortgage rates at the end of last week held steady near record lows. According to the Freddie Mac weekly survey, the average interest rate on a 30-year fixed-rate mortgage (FRM) reached 4.57% last week. Over time, according to the FRBSF economists, refinance rates often mirror the rise and fall of interest rates, but with such a volatile market, trends in prepayments are becoming harder to pin-down. “Despite this basic relationship in the aggregate data, the mortgage finance literature is replete with empirical evidence documenting how individual mortgage borrowers often don’t follow optimal prepayment strategies,” according to the FRBSF report. Using loan-level data from Lender Processing Services (LPS), economists at the FRBSF charted a random sample of more than 75,000 first-lien, owner-occupied mortgages with closing dates ranging from January 2000 to March 2010. They built a model based on factors such as unemployment rates and who owned the mortgage. The model’s prediction of a 6.5% prepayment rate for all mortgages in Q102 only slightly strayed from the actual rate of 5.75%. But moving to Q110, that same model predicted 5.26% of homeowners would elect to prepay under the measured market conditions such as the low mortgage rates. But according to the LPS data, only 2.5% of them did. “Given the number of mortgages outstanding in the first quarter of 2010, this translates into about 1.2m mortgages not prepaid that the model predicts would have been prepaid. Evidently, the usual rise in prepayments that accompanies a prolonged period of low interest rates was offset by some other factor or combination of factors,” according to the report. The economists concluded that despite attractive rates, mortgage prepayments have continued to underwhelm due to other historic factors. For instance housing demand remains weak. What little of it there is seemed to be propped up by the homebuyer tax credit, as shown in the latest report from the National Association of Realtors (NAR). In May, pending home sales dropped 30% from the previous month following expiration of the tax credit. Although foreclosure rates have seen recent drops, they continue to stay at historic highs. According to RealtyTrac, an online foreclosure marketplace, foreclosure filings dropped 5% over the first half of 2010, but more than 3m properties should receive a filing by the end of the year. Each, according to the report from the FRBSF, could be the reason behind underwhelming prepayment rates. “These missing factors may include a possible tightening of mortgage terms for borrowers who previously enjoyed much easier access to credit, and weak housing demand that is suppressing the trade-up market and preventing distressed borrowers from selling their houses and avoiding foreclosure,” the report concludes. Write to Jon Prior.
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