Jim Reber: Cash flow or no?

Have we entered a new trading range for investment yields? That’s the subject of great conversation among market participants, Federal Reserve and Treasury officials, community bankers and investment brokers. What appears fairly clear, though, is that we have more yield in the intermediate- to long-term than most people thought we’d have at the start of 2021.

This brings up several other topics of import for community bank portfolio managers. One of which is that since longer rates have risen, they could either decline or rise from here; at the start of the year, “rates up” was the only plausible option. And if 2020 taught investors in mortgage-backed securities (MBS) anything, it’s that the cash flows from them can be hugely unpredictable. Prepayments from refinancing set all kinds of records this past year, in many cases sending community bankers scrambling to stay invested while having to constantly adjust their portfolios’ book yields and effective durations.

What we’ve learned

More recently, in what seems to me as a triumph of capitalism, mortgage underwriters and broker-dealers have gotten much more granular in providing details that underpin MBS pools.

For example, borrowers’ FICO (credit) scores, average loan balance, loan ages, geographic dispersion, loan servicer and even the originator can have an impact on the propensity for the collateral loans to prepay either faster or slower than average.

This is not a minor consideration for community bankers. The majority of bonds owned by the industry are related to mortgages, and by far most of them are single-family pools, which have virtually no prepayment protection. By teasing out certain details in a given MBS pool, today’s investors can get a better idea of how their own pools may behave relative to the overall mortgage market. By including—or excluding—certain variables in their purchase requirements, community banks can much more accurately right-size their prepayment and cash-flow profiles.

High-low contexts

By now, it’s understood that the current outstanding borrowers’ rate is one of the biggest determinants in predicting how fast a given set of loans may prepay. Attendant to that is the term of the pool: The shorter the remaining life, the faster they’re likely to prepay, up to a point, at which the “burnout” phenomenon will occur.

Related to this, what has also been well documented is the impact of loan size on refinance activity. The larger the remaining principal value, the faster the prepayment activity. Same thing with FICO scores: The better the credit, the more options a borrower has. What is probably not yet understood by many MBS buyers is that collateral in certain states will deviate from national averages. California? Fast. New York, Florida and Texas? Slow.

A similar story attaches to certain mortgage servicers; it is generally believed that loans serviced by nonbanks like Rocket Mortgage from Quicken Loans will be fast, as nonbanks actively market refi opportunities to their customers.

Some community banks want—and need—a lot of cash flow in the near future; others prefer to lock in their investments for some time and push their durations out on the horizon. The table below is a digest of some factors that are more highly correlated to mortgage refinancing activity. By requiring or eliminating one or some of these variables in your MBS purchases, you too can create a DIY cash-flow profile.