Weekly mortgage applications numbers and what they mean (Part 4)

Market Realist

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The MBA Refinance Index was basically flat for the week ending July 19

The Refinance Index fell to 0.6%, to 2,336 from 2,351, even though the average 30-year fixed-rate mortgage fell from 4.45% to 4.35%. The ten-year bond yield fell 6 basis points. The bond market has been re-adjusting to the idea that we may see the end of quantitative easing in fall. That said, it seems to have stabilized at these levels, at least for the moment.

(Read more: Radar Logic futures curve predicts flat real estate prices until September 2014)

MBA reported that the share of refinance applications dropped to 63%. Most originators are anticipating a more purchase-driven market going forward and believe we’ve seen the lows in interest rates. If we have in fact seen the lows in interest rates, home price appreciation will drive refinance activity more as previously underwater homeowners eventually get back to positive equity and take advantage of lower rates. Slowing refinance activity could be a negative for originators like PennyMac (PMT) and Redwood Trust (RWT).

(Read more: Spread between 30-year fixed rate mortgages and 5/1 ARMS tightens)

Implications for mortgage REITs

Refinancing activity affects prepayment speeds, which is a critical driver of mortgage REIT returns. Prepayment speeds occur because homeowners are allowed to pay off their mortgage early, without penalty, and when interest rates fall, those who can refinance at a lower rate do. This is good for homeowners. However, it isn’t necessarily good for mortgage lenders—especially REITs. When homeowners prepay, the investor loses a high-yielding asset and is forced to re-invest the proceeds in a lower-rate investment. This means lower returns going forward. A rise in prepayment speeds could negatively affect REITs, like American Agency Capital Corp. (AGNC), Annaly Capital Management, Inc. (NLY), Hatteras Financial Corp. (HTS), CYS Investments, Inc. (CYS), and Capstead Mortgage Corporation (CMO). That said, the increase in rates has basically put prepayment worries on the back burner for the REITs.

However, as rates increase, prepayments become less of a problem for REITs. But increasing rates bring their own set of problems, and REITs face mark-to-market hits on their portfolio and must adjust their hedges to a more volatile interest rate environment. Mortgage-backed securities outperform in stable interest rate environments, but they’re highly vulnerable to interest rate shocks.

(Read more: Fannie Mae MBS continue to sell off)

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