Morningstar Credit Ratings issued a statement Thursday stating they expect a reduction in mortgage prepayments, which could lead to increased default risk in securitizations of residential mortgage.
“We anticipate that mortgages with loan-to-value ratios under 60 percent and interest rates under 6 percent will exhibit the biggest drop in prepayments,” said Morningstar analysts Gaurav Singhania and Olgay Cangur. “By our estimate, the concentration of this rate-sensitive borrower is 2.5 times higher in the post-crisis transactions.”
The analysts expect rising interest rates to cause a disproportionately greater reduction in prepayments for post-crisis originations that have a higher concentration of low interest rate, low LTV mortgage.
“Using the CoreLogic, Inc. Home Price Index to determine the LTVs, we expect approximately $164.77 billion of private-label mortgages, which represents nearly a third of the nonagency universe, are likely to see their prepayments cut in half if the rate refinancing incentives disappear,” Singhania and Cangur said.
The analysts said the Fed raising its benchmark overnight lending raid to the .50 to .75 percent range from the .25 to .50 percent range will make financing a home more expensive.
“In the benign U.S. interest-rate environment of recent years, the rapid pace of prepayments arguably has played a role in containing defaults,” they said. “Tighter mortgage underwriting, low LTV requirements, and 100% due diligence in post-crisis jumbo RMBS transactions have limited defaults to only a handful of loans over the past seven years.”
Rising interest rates, they say, could potentially drastically cut prepayments and increase risk in RMBS transactions.
“Much will depend on the regulatory landscape under the Trump administration,” they said.
Morningstar analysts found prepayments were sensitive to interest rates whether they be agency or private-label RMBS deals, which borrowers with more equity in their homes being more rate sensitive.
“We found that borrowers with more equity in their homes prepay more often and respond earlier to a smaller reduction in rates compared with borrowers with less equity in their homes,” they said.