While mortgage rates remain stubbornly high by recent historical standards, accurately forecasting MSR performance and valuations requires a thoughtful evaluation of loan characteristics that go beyond the standard “refi incentive” measure.
As we pointed out in 2023, these characteristics are particularly important when it comes to predicting involuntary prepayments.
This post updates our mortgage origination trends for the first quarter of 2024 and takes a look at what they could be telling us.
Average credit scores, which were markedly higher than normal during the pandemic years, have returned and stayed near the averages observed during the latter half of the 2010s.
The most credible explanation for this most recent reversion to the mean is the fact that the Covid years were accompanied by an historically strong refinance market. Refis traditionally have higher FICO scores than purchase mortgages, and this is apparent in the recent trend.
Purchase markets are also associated with higher average LTV ratios than are refi markets, which accounts for their sharp rise during the same period.
Consequently, in 2023 and 2024, with high home prices persisting despite extremely high interest rates, new first-time homebuyers with good credit continue to be approved for loans, but with higher LTV and DTI ratios.
Between rates and home prices, borrowers simply need to borrow more now than they would have just a few years ago to buy a comparable house. This is reflected not just in the average DTI and LTV, but also the average loan size (below) which, unsurprisingly, continues to trend higher as well.
Recent large increases to the conforming loan limit are clearly also contributing to the higher average loan size.
What, then, do these origination trends mean for the MSR market?
The very high rates associated with newer originations clearly translate to higher risk of prepayments. We have seen significant spikes in actual speeds when rates have taken a leg down — even though the loans are still very new. FICO/LTV/DTI trends also potentially portend higher delinquencies down the line, which would negatively impact MSR valuations.
Nevertheless, today’s MSR trading market remains healthy, and demand is starting to catch up with the high supply as more money is being raised and put to work by investors in this space. Supply remains high due to the need for mortgage originators to monetize the value of MSR to balance out the impact from declining originations.
However, the nature of the MSR trade has evolved from the investor’s perspective. When rates were at historic lows for an extended period, the MSR trade was relatively straightforward as there was a broader secular rate play in motion. Now, however, bidders are scrutinizing available deals more closely — evaluating how speeds may differ from historical trends or from what the models would typically forecast.
These more granular reviews are necessarily beginning to focus on how much lower today’s already very low turnover speeds can actually go and the extent of lock-in effects for out-of-the-money loans at differing levels of negative refi incentive. Investors’ differing views on prepays across various pools in the market will often be the determining factor on who wins the bid.
Investor preference may also be driven by the diversity of an investor’s other holdings. Some investors are looking for steady yield on low-WAC MSRs that have very small prepayment risk while other investors are seeking the higher negative convexity risk of higher-WAC MSRs — for example, if their broader portfolio has very limited negative convexity risk.
In sum, investors have remained patient and selective — seeking opportunities that best fit their needs and preferences.
So what else do MSR holders need to focus on that may may impact MSR valuations going forward?
The impact from changes in HPI is one key area of focus.
While year-over-year HPI remains positive nationally, servicers and other investors really need to look at housing values region by region. The real risk comes in the tails of local home price moves that are often divorced from national trends.
For example, HPIs in Phoenix, Austin, and Boise (to name three particularly volatile MSAs) behaved quite differently from the nation as a whole as HPIs in these three areas in particular first got a boost from mass in-migration during the pandemic and have since come down to earth.
Geographic concentrations within MSR books will be a key driver of credit events. To that end, we are seeing clients beginning to examine their portfolio concentration as granularly as zipcode level.
Declining home values will impact most MSR valuation models in two offsetting ways: slower refi speeds will result in higher MSR values, while the increase in defaults will push MSRs back downward. Of these two factors, the slower speeds typically take precedence. In today’s environment of slow speeds driven primarily by turnover, however, lower home prices are going to blunt the impact of speeds, leaving MSR values more exposed to the impact of higher defaults.
