Changing Market Complicates Hedging

With evidence mounting (not for the first time in recent years) that interest rates are starting to trend upward, the people who hedge mortgage servicing portfolios may be able to breathe a sigh of relief.

But not for long. In some regards, hedging becomes more difficult - and more expensive - in a rising rate environment.

That is in part because some of the financial instruments typically used to hedge a mortgage portfolio increase in price with rates rising and expected to rise further.

But changes in the housing market are also a factor, because they are leading to an evolution in the nature of refinancing activity.

The unprecedented refinancing binge of 2002 and 2003 created distortions in mortgage prepayment activity that will take time to come into focus, but a few things are clear. Consumers have become more familiar with their refinancing option, and an increasing number are now comfortable refinancing to tap into home equity, consolidate debts, or change the terms of their mortgage loan.

And changes in the types of loans that consumers are using will also have an impact on prepayment behavior, which could affect hedging choices. Many banks report that more than 75% of their adjustable-rate loan production is comprised of hybrid loans, which stay fixed for a period of years before converting to one-year adjustable-rate products. The prepayment behavior of this growing universe will be a concern for lenders.

And the effect of home price growth is also a factor in considering how prepayment behavior is evolving. Despite predictions of a slowdown, home values have continued to grow at a fast pace this year. In the second quarter, existing home values rose at an annual rate of 10%, according to Freddie Mac. Most economists expect the pace of appreciation to slow down, but for the moment, rising values are adding to the temptation for some homeowners to tap into their equity.

And also according to Freddie Mac, homeowners are increasing their leverage, or increasing their loan-to-value ratios, perhaps in response to rising house prices. What impact will that have on prepayments?

The secondary market agency predicts that annual mortgage originations will average nearly $3 trillion per year over the next decade and that the total amount of mortgage debt outstanding will grow at an 8.25% annualized rate. That would bring total mortgage debt outstanding, currently just over $7 trillion, to more than $17 trillion.

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