When Rates Fall, Mortgage Volume Grows
As 2019 comes to an end, many mortgage lenders are looking back on a successful refinance-boom across the entirety of the year. The average 30-year fixed mortgage refinance rate has fallen from 5.35% to 3.95% over the last twelve months, while the funded-loan mix has shifted from 28% refinances to 60% refinances. Given that the seasonally adjusted purchase volume is flat year-over-year, this shift represents a 112% increase in total refinance volume from 2018.
The interest rate decline has been a surprising reversal from 2018, given that the general expectation was that rates would plateau or continue their rise in 2019. The primary driver of the interest rate shift was the US Federal Reserve Open Market Committee (FOMC) interest rate policy decisions. Following 4 decisions to increase the Federal Funds Rate through 2018, the FOMC chose to keep rates flat through early 2019 before lowering rates beginning July 31 due to weak inflation and business investment. Additional Fed Funds Rate cuts followed in September and October, for a total decrease of 75bps.
In addition to the unpredicted decline in short term rates, another infrequent event occurred in interest rates in 2019: the US Treasury yield curve inverted. A yield curve inversion is a situation where the short-term yields on debt (in this case US Treasury bonds) are higher than the long-term yields on similar debt. This situation is strange in that it implies that short term lending (2-year bonds in this case) is a higher risk - indicated by the higher rate - than long term lending (10-year bonds), but that may not necessarily be the driver of this situation. The yield curve first inverted in mid-August of 2019 and remained there through September.
While many explanations were offered for this inversion, the interesting effect on mortgages was the narrowing rate spread between Adjustable Rate mortgages and 30-year Fixed Rate mortgages. In late 2018, funded 7/1 Conforming ARMs had lower rates by 75bps, compared to a 30Y FRM. By August 2019, the spread had narrowed to 40bps, resulting in ARMs changing from 4-5% of conforming originations to 1% as the benefit of a lower, but variable, rate narrowed significantly. Conversely, the impact of yield curve inversion on Non-Conforming loans was much more muted as spreads remained essentially flat. This is most likely due to bank funding rates remaining unchanged for balance-sheet lending.
As rates fall, the first customers to begin refinancing are generally the Jumbo loan borrowers. As early as February 2019, when rates had fallen 35-40bps from their peaks in December 2018, Non-Conforming originations were made up of nearly 50% refinancings, whereas Conforming originations were composed just 35% refinancings. This is expected as larger loan balances present a larger nominal change in monthly payment. For example, a 40bp rate reduction for an average conforming loan would save a borrower approximately $700 per year in payments. However, the same 40bp rate reduction for the average non-conforming loan would save the borrower approximately $2,300 annually - covering most or all of the costs of a refinance in one or two years!
Looking ahead, 2020 is not expected to be as strong a year in terms of volume as 2019. Fannie Mae currently forecasts that total originations will decrease by 5%, consisting of an increase in purchase by 7% and a decline in refinance by 22%.
The Mortgage Bankers Association similarly predicts that total originations could decrease overall by 8%, with a slight increase of 2% in purchase and a decrease of 25% in refinance. Interestingly, these predictions are accompanied with rate projections that show slowly declining rates, falling 10-20 bps over the year. As of December 2019, the average 30-year conforming interest rate was only 20bps above the lowest average rate seen during the 2016 refi-boom (a year in which refi originations totaled $890bn compared to the $860bn in 2019), indicating that there may be a bright spot among the dour predictions. It may only take one additional rate cut from the Fed to create an extension of or the impetus for another refinance expansion.
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