Refi flow slows

The Wall Street Journal recently ran a story with this misleading headline: “Mortgage Windfall Misses Many.” Even with current fixed-rate mortgage rates under five percent, a nearly historic low, the article reports an absence of refinancing activity compared with previous eras.

Investment bank Credit Suisse estimates that 37 percent of current borrowers with 30-year fixed-rate mortgages (about $1.2 trillion worth) have mortgage rates at six percent or higher. More than half of those homeowners could save 75 basis points (3/4 of a percentage point) by refinancing at current rates; many could save a full percentage point.

Still there is a limited refinance flow. This is due to several factors: falling house prices resulting in evaporating equity, stricter lending standards making it more difficult to qualify and higher fees imposed on refinancing applications by Freddie and Fannie. In 2003, when mortgage rates were similar, $2.9 trillion in refinanced mortgages closed; in 2009, only about $1.2 trillion were.

Refinancing is a good thing but has been hampered by underwater borrowers, low prices, hesitant lenders, higher fees from lending agencies and burdensome bureaucratic rules from government assistance programs. The Obama Administration’s programs to help borrowers refinance have not worked well for many borrowers. 

The United States is one of only two countries that has traditionally relied (even these days) on the long-term, fixed-rate mortgage (FRM). Ever since the early 1930s when FHA invented the FRM, American households have been able to shift the risk of higher future mortgage interest rates to the lender by using the FRM in exchange for a premium built into the mortgage rate. An important artifact of this tradition is the refinancing decision, especially whenever mortgage interest rates decline.

There are three recent refinancing eras. First, before there was significant usage of second mortgages and mortgage lines of credit, refinancing was used to free up homeowners’ equity, usually for consumption. The growing equity component was a result of house price appreciation over prior decades; refinancing otherwise suitable mortgages was necessary in order to get access to newfound homeowner wealth.

Next came the rise of second mortgages and home-equity lines of credit. This was the financial systems’ response to the expressed needs of borrowers: homeowners did not wish to refinance their primary mortgages, they simply wanted to tap the growing equity balances in their homes. This is the period in which individuals relied upon housing as their personal “piggy banks.”  The financial system provided products to facilitate these needs efficiently and inexpensively.

Both of these developments above stemmed from appreciation in house prices. But another incentive occurs when mortgage rates fall. The FRM guarantees that the borrower pays the same rate of interest regardless of what happens to rates in the future.  If rates increase, the borrower benefits by paying the historic contractual rate (i.e., the financial gain from higher interest rates then accrues to the borrower).  If rates decrease, the borrower has the opportunity to prepay the mortgage balance and immediately refinance the balance (i.e, the opportunity loss resulting from lower interest rates is avoided with prepayment by the borrower and a new repayment schedule at the lower rates). This is the prepayment option embedded in FRMs and also the reason FRMs have higher interest rates than ARMs.

So, like clockwork for many years, as mortgage rates fell, refi activity increased.  The lower mortgage rates became, the greater the incentive to refinance FRMs at the low rates.  Refinanced mortgages even exceeded new originations when rates were at historic lows. In addition, exercising the prepayment option was the most important event for holders of mortgage-backed securities (known as prepayment risk).

The ability to refinance mortgages is one of the most significant differences between real estate and corporate debt: the right to prepay (which is embedded in the FRM) makes mortgage finance unique. When ARMs first appeared, some observers were not sure how to compare these mortgages. However, market participants were not confused: refinancing took place whenever interest rates fell, enabling borrowers to capture the financing gain resulting from the decline in rates. Currently, we are in a period when refinancing has slowed considerably much to the chagrin of borrowers and for the economy as a whole.

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This entry was posted on Wednesday, March 24th, 2010 at 6:00 am and is filed under Economics. You can follow any responses to this entry through the RSS 2.0 feed.