While expectations have called for refinances to drop as interest rates increased, subprime loans have continued to refinance at surprisingly high levels.
Â Â Â According to data from LoanPerformance, a San Francisco-based analytics firm, subprime adjustable-rate mortgage (ARM) prepayments have increased consistently since 2000. For instance, one year into the life of the loans, the 2003 vintage showed a cumulative prepayment rate (CPR) of 40% – more than twice IndyMac the rate of loans originated in 2000. Vintages from 2004 also prepaid faster than product from 2003, according to a report by Paul Calem, vice president of research for LoanPerformance, and Ralph DeFranco, vice president of risk management for Triad Guaranty.
Â Â Â LoanPerformance's models don't explain why loans from 2003 and later began prepaying so fast. After mid-2003, subprime loans – especially adjustable-rate mortgages – began prepaying faster than the company's models predicted, based on interest rates, loan size and other factors, states the report, ‘Why Have Subprime Loans Been Prepaying So Fast?’ published in LoanPerformance's The MarketPulse electronic newsletter. Interest rate conditions coming into play in 2003 were unlike any seen since 1996, the analysts note. Prepayments continued to accelerate through 2004, reaching pay-off speeds well above predictions.
Â Â Â High subprime refinance rates are not surprising, says George Yacik, vice president of SMR Research Corp., a research firm based in Hackettstown, N.J. In a higher-rate environment, the subprime share of refinances typically tends to increase versus rate-driven transactions.
Â Â Â ‘The psychology of consumers has changed quite a bit over the last couple years,’ Yacik says. ‘In the old days, people refinanced just to lower their rate. Now they refinance for other reasons. It doesn't necessarily have to involve an interest rate reduction.’
Â Â Â That's especially true in the subprime world, where consumers more frequently refinance to extract equity – regardless of other factors. ‘It could be a low- to high-rate refi,’ he points outs.
Â Â Â With more reasons for consumers to refinance, the industry could see heavier refi volumes even in a rising-rate environment, Yacik adds. Refinances comprised 50% of loan production for the first half of the year, down from 58% for the first half of 2004, according to SMR Research. They represented 53% of volume for all of 2004. ‘It was off a little, but not a lot,’ he says.
Â Â Â Industry observers, Calem and DeFranco note, have many theories for the relatively fast refinancing rate of subprime loans:
Â Â Â * Booming home values in many areas have motivated homeowners to cash out equity.
Â Â Â * An increasing availability of low-down-payment loans makes it easier to extract even more equity.
Â Â Â * Interest-only loans that reduce short-term payments have attracted borrowers' interest.
Â Â Â * Subprime loans tend to be ARMs or hybrid ARMs, which are more likely to refinance than fixed-rate product. Concerns about rising interest rates have prompted many of those borrowers to refinance. Those with hybrid ARMs have locked into a fixed rate or refinanced into another hybrid to at least delay the possibility of substantial increases in their monthly payments. Although those opting for another hybrid may be only delaying a rate increase, they want to avoid the higher current cost of fixed-rate loans.
Â Â Â * Subprime borrowers can refinance into a lower interest rate if their credit improves – and they may be more aware of that ability due to lenders' marketing efforts. Homeowners who use cash-out funds to pay off credit card debt can improve their credit score, then can refinance again at a lower rate.
Â Â Â * Lenders are more aggressively marketing to subprime borrowers following the drop in prime refinance volume. While marketing efforts may have increased, the analysts don't see a price war between lenders. Determining the impact of interest-only products is difficult due to a lack of data, they say. While some subprime refinancers opt for interest-only products to cut monthly payments, the loans are used more for purchase money mortgages than for refinancings.
Â Â Â Extracting equity from increasing home values and avoiding increasing interest rates are more valid reasons, Calem says. Although rates did not increase as expected, the expectation of rising rates has been key in motivating many to move from ARMs and hybrids to either fixed-rate loans or other hybrids.
Â Â Â Subprime borrowers are refinancing despite prepayment penalties. About 70% of subprime loans refinanced in late 2004 featured those penalties, according to LoanPerformance data. Lower interest rates may have at least partially offset penalties, and rising home values can allow homeowners to roll the costs into the new mortgage.
Â Â Â Plus, some borrowers want to avoid increases in monthly payments. Those consumers try to set monthly payments at debt targets as part of their budget planning, regardless of prepayment penalties, the LoanPerformance paper states. This could mean that subprime refinances are causing adverse selection. Borrowers refinancing may have credit that's lower than their scores indicate and may be less able to weather future rate increases.