With significant home price gains over the last two years, U.S. homeowners are sitting on vast, mostly untapped wealth. Nationally, home prices are up an aggregate of 28% over the last two years, with some regions performing even better. But unlike other periods of strong home price gains, cash-out refinancings lagged overall refinancings during the pandemic rate-rally. In this short article, we look at cash-out refinancings over time, and their potential impact on prepayments, especially on discount cohorts.
A historical perspective
In the early 2000s, mortgage rates fell nearly 200bp, triggering a massive refinancing wave as well as a rally in home prices that lasted well into 2005.
During this early millennium rally, the market saw significant cash-out refi activity with homeowners borrowing at then-historically low rates to free up cash. The market even saw refinancing activity in mortgages with note rates below the prevailing market rate. In 2002, CPRs on some discount cohorts hit the low to middle teens, which many participants attributed to cash-out refinancing. Resetting a mortgage 50 basis points higher can nevertheless often lead to overall lower debt servicing when borrowers use cash-out refis to consolidate auto loans, credit cards and other higher-rate unsecured borrowings.[1] In the early 2000s, this cash-out refinancing activity led to overall faster speeds and a higher S-curve for out-of-the-money cohorts. How does 2002-03 cash-out refi activity compare to today? In the early 2000s, issuance of cash-out mortgages, as a percentage of the total market, varied between 1% and 2.5% of the outstanding mortgage universe each month.
Since the onset of the pandemic, that figure has not experienced the same kind of spike, hovering around just 0.9%.[2]
In 2002-03, most of these cash-out borrowers refinanced into lower rates, but a sufficient number took out mortgages at same or higher rates to drive prepayments on discount MBS into the low teens CPR (see black s-curve below). By comparison, out-of-the money speeds today (the blue s-curve) are approximately 4 CPR slower.
The nearly 30% rally in home prices during the pandemic has further strengthened a solid housing market. Today’s borrowers have substantial equity in their homes, leaving many homeowners with untapped borrowing power, shown in the market-implied LTVs below. From an origination standpoint, mortgage lenders have sufficient capacity to support any uptick in cash-out refinancing as rate-term refinancing volumes decline.
Any growth in cash-out refi issuance is likely to come on loans with note rates close to the prevailing mortgage rate. If a homeowner needs to generate cash for a large purchase, it can make economic sense to refinance an existing loan into a new loan with rates as much as 25bp or 50bp higher, rather than incur even higher (and shorter-term) interest rates on credit cards or personal loans. Therefore, any uptick in cash-out refinancing will likely have a larger effect on prepayment speeds for MBS that are either at-the-money or slightly out-of-the-money. This uptick may mitigate some of the extension risk in near-discount mortgages, especially in non-spec cohorts where refinancing frictions are lower. While the past two years have seen substantial changes, positive and negative, in overall refinancings, cash-out refis have largely not followed suit. But a significant home price rally, coupled with strong economic activity and excess originator capacity, could change that trend in the upcoming year.
