Interest Rates, Refinancing, and the Threat to Mortgage-Backed Securities
While not the first viral illness to be labeled a “pandemic,” it goes without saying that the pervasive spread of the COVID-19 coronavirus is an unprecedented event in modern times. Likewise, the fallout of this pandemic, including that of economic significance, is equally substantial, and its full effects are still far from known. 2020 felt the sharpest spike in unemployment, with the national percentage (approximately 14.7% in April and still over 13% in May) comparable only to the Great Depression. This year has also seen one of the most severe and sudden stock market shocks in history, with the NASDAQ falling over 30% from its February peak in March. Despite impressive rebounds in most stocks, the forecast of the real US economy remains bleak, with some analysts expecting a 50% reduction in yearly GDP growth in 2020. Such devastating outlooks have persisted despite the historic $3 trillion stimulus package passed by Congress, as well as the Federal Reserve’s pledge to provide “unlimited” monetary support to the economy. Drastic times certainly do call for drastic measures, but even these great attempts are proving ineffective to shield many Americans from the effects of this economic slowdown.
Low Rates Induce Refinancing
As with all periods of economic stagnation, markets are currently being met with a lower cost of borrowing (i.e. falling interest rates). However, this pandemic-induced “Coronavirus Recession”, through both reduced demand for lending amidst uncertainty, as well as stimulus attempts by the Fed, has resulted in the lowest market interest rates in almost 100 years, with the 10-Year Treasury Note offering a meager 0.66% yield at the start of June. Falling interest rates are the market’s natural attempt (further driven by monetary policies such as quantitative easing) to make borrowing more attractive for corporate investments to fuel future growth. However, high uncertainty, accompanied by several hindrances on economic growth, such as border closings and broken supply chains, has kept new loan issuances low. There is also increased fear from lenders, spurred by the all-too-recent 2008 financial crisis, that over-extending credit lines, even to normally reliable borrowers, could make matters worse. The outcome, then, is reduced eligibility for new loans despite the attractive rates.
Despite such limitations, these historically low-interest rates do present what many are considering a golden opportunity for those already managing outstanding loans: debt refinancing. This has become particularly prevalent in the housing market, as the number of mortgagors electing to refinance their homes continues to climb. In March, “nearly 13 million [mortgage loan] borrowers” were positioned to “lower their current rates by at least 75 basis points,” or 0.75%, by refinancing (CNBC, 2020). This striking influx of refinancing applicants was largely set off due to reports by Fannie Mae and Freddie Mac, the two government-sponsored enterprises designed to provide liquidity to the US housing market. In early March, Freddie Mac reported that “30-year fixed mortgage fell to 3.29%.” This was the lowest rate recorded since the company was chartered in 1971—even lower than rates during the great recession—and homeowners responded with a 30% jump in refinancing applications the following week (HW Media, 2020).
The Impact on Mortgage-Backed Securities
While the opportunity to refinance may prove highly advantageous to those with already outstanding mortgages, allowing them to reduce their monthly payments in a time of economic turmoil, there are other financial parties affected that are not so excited. A key example is those holding "Mortgage-Backed Securities", as they are suddenly exposed to a heightened degree of financial risks due to the accelerated repayment of old mortgages. Mortgage-Backed Securities (MBS) are a type of fixed-income security with cash flows derived from the underlying payments on specific mortgages. The holders of these mortgages (usually the bank that issued them) may sell them to financial intermediaries, which then“repackage” their cash flows into bond-like instruments to be purchased by individuals and institutional investors. However, because the cash flows of these securities are contingent on the cash flows of the underlying mortgages, refinancing of all or most of these mortgages can lead to undesirable shifts in the payment schedule of the MBS.
The primary risk, related to refinancing, for MBS holders is the realization of prepayment risk. Prepayment risk is defined as the risk associated with “premature return of principal on a fixed-income security” (Investopedia, 2020). When mortgages are “prepaid” through a refinancing agreement, the cash flows intended to come over a stated period of time (ex: 15 or 30 years) are received all at once. As a result, the MBS is essentially “called in,” as a bond may be, and the security holders are repaid their full principal early. This means the investor is no longer receiving interest on their previously invested principal, as the prepayment by mortgagors has resulted in the securities maturing early (also known as contracting). Therefore, the investor is forced to reinvest in a new security or asset if they are to receive additional returns on their principal.
This sudden need to reinvest holds results in the adequately named “reinvestment risk” or the risk of investing principal or past gains into lower-yield securities as a result of fluctuating interest rates. As previously stated, borrowing rates are at historic lows. Therefore, those investors facing contraction of their MBS holding are now faced with the inability to reinvest in securities of comparable risk levels for the same rate of return. Now, their reinvestment options offer significantly reduced interest rates (for similar risk levels), and therefore a lower realized ROI.
In the past, financial institutions have developed structuring mechanisms for MBS and other similar investments to redistribute this prepayment and refinancing risk among some investors more than others. Dividing cash flows into “tranches” is a relatively simple and widespread method to do this, and it has been considered adequate for decades.. However, the sheer scale of referencing, and the associated prepayment of old mortgages, occurring today has made many of these structured financial mechanisms ineffective. Only time will tell the exact degree of influence, but we will likely see restructuring of a range of Mortgage-Backed Securities, as well as similar financial instruments, over the next few years. The coronavirus shutdown has shown the world just how devastating a global pandemic can be, and those creating financial instruments will have no choice but to reassess their strategies amid the threat of future similar externalities.
Works Cited
Brenda Richardson (May 8th, 2020); “Low Interest Rates Push Refinance Activity By Millennials To A Record High”; Forbes; Retrieved From: https://www.forbes.com/sites/brendarichardson/2020/05/08/low-interest-rates-push-refinance-activity-by-millennials-to-a-record-high/#1c2578eafbab
Diana Olick (March 6th, 2020); “Record number of borrowers can now save on a mortgage refinance as rates drop from coronavirus fears”; CNBC; Retrieved From: https://www.cnbc.com/2020/03/06/record-number-of-borrowers-can-save-on-mortgage-refinancing.html
Heather Long and Andrew Van Dam (May 8th, 2020); “U.S. unemployment rate soars to 14.7 percent, the worst since the Depression era”; The Washington Post; Retrieved from: https://www.washingtonpost.com/business/2020/05/08/april-2020-jobs-report/
James Chen (Jan 22nd, 2018); “What Is Prepayment Risk?”; Investopedia; Retrieved From: https://www.investopedia.com/terms/p/prepaymentrisk.asp
US Dep. of the Treasury; “Daily Treasury Yield Curve Rates”; Retrieved from: https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/textview.aspx?data=yield
