The loans, bundled in government-backed mortgage bonds, are becoming oversized as home prices rise, a change that could hurt the performance of the securities over the next year.
The Federal Housing Finance Agency said last week that loans that can be bundled into agency mortgage bonds could go as high as $ 647,200, up nearly $ 100,000 from last year. While this limit increases annually based on average US house prices, it is the largest increase ever in both absolute and relative terms.
"The appreciation of home prices is the basis for the larger loan amounts, mainly supported by lower interest rates and the strong economy," said Michael Khankin, director of MBS research at Barclays, in an interview.
But there are other factors that contribute to the higher average loan amounts. For one thing, the Fed has begun cutting its purchases in the mortgage-backed securities market and has already reduced its direct monthly purchases from $ 40 million to $ 35 billion.
The Fed tended to buy securities with higher average loan sizes relative to the rest of the market, so the mortgage sizes in bonds available to investors are likely to increase, Erica Adelberg, an analyst at Bloomberg Intelligence, said in a 3 December report.
With economists and markets broadly predicting higher interest rates over the next year, refinancing is likely to make up a smaller proportion of the loan volume and home purchase loans likely more in the near future.
“Unlike refis, purchase credits are inherently home-price pegged and, given the appreciation we've seen in home prices, they are considerably larger than refi credits,” said Khankin of Barclays. "If interest rates were to rise, the proportion of purchase credits in the market would increase and loan sizes would also increase."
The US has seen stormy house price gains this year, even if the rate of growth has slowed somewhat. Nationwide, prices rose 19.5% year over year in September, according to the latest available data from the S&P CoreLogic Case-Shiller Index. According to the National Association of Realtors, completed home purchases are set to exceed 6 million in 2021, most in 15 years.
Prepayment risk
Higher credit makes mortgage bonds riskier for investors. When homeowners have larger loans, they are more likely to refinance themselves with relatively minor drops in interest rates, as the monthly savings in dollars are greater than with a smaller loan.
This tendency for borrowers to refinance sooner means that when interest rates fall, the prices of mortgage bonds rise less than other, less convex bonds such as government bonds. Higher average loan sizes could lead to larger spreads on mortgage-backed loans in the next year, BI's Adelberg wrote. In other words, the securities could outperform government bonds.
A by-product of the larger overall loan sizes is that smaller loans with better prepayment features, such as: For example, loans in excess of $ 275,000 can be carved out of pools based on generic features such as the coupon set known as TBA pools. They could instead be securitized in specific pools, said Khankin, in which investors pay to identify specific credit characteristics they want. This could lead to TBA pools having even larger average loan sizes, he added.
