Placing prepayment penalties on the Christmas table

It’s the time of the year in mortgage finance to begin developing our resolutions. After a year that saw more and more money being pumped into the economy it’s about time everyone started looking at stimulus options, no matter how small, that don’t involve a taxpayer backstop. Indeed, politicians seem to spend taxpayer dollars at will and after a challenging year, 2011 needs to find a period of austerity. Considering that the government-sponsored enterprises and Ginnie Mae will dominate the mortgage finance space yet again next year, we need options to reduce the exposure the average American has to those bonds. One way to convince investors to buy mortgage-backed securities, outside a government guarantee, is to implement mortgage prepayment penalties. In a conversation with investor Wilbur Ross, he points out that the United States is unique with the combination of 30-year, fixed-rate mortgages that are repayable with no penalty at any time. “It makes these instruments difficult to hedge and restricts private market interest. There are other countries with similar ownership levels without prepayment penalties. I don’t think a single homeowner would be dissuaded from getting a home with prepayment penalties; they would be happy to pay at par,” said Ross. In Europe, lifting prepayment penalties also provides lift to the economy, although not anywhere to the extent of quantitative easing. In 2007, the Bersani Decree in Italy eliminated prepayment penalties on certain mortgages and set off the highest rate of prepayments since 2000. Spreads on the bonds jumped 13 basis points to 14 bps to 40 bps on the back end. It was a minor bump to the Italian economy, but a bump nonetheless. In the United States, 2011 outlook reports from several large banks point to declining mortgage prepayment rates next year in an environment of steadily rising interest rates. While the rates push out borrowers looking to refinance, the news will be well accepted within the mortgage bond investor circle. “Prepayment burnout results in a pool becoming less sensitive to refinance incentives,” explains an outlook report from the Royal Bank of Scotland. MBS strategists at Bank of America Merrill Lynch, Chris Flanagan and Vikram Rao, say the fall in prepayments means it’s a good time to invest in mortgages as the related “extension has now been fully priced in” to the bonds. And considering far fewer people will prepay, why not make it more of a guarantee by establishing penalties? Reducing prepayment risk in MBS even further will only make the bonds a hotter commodity, thereby helping to keep liquidity flowing well into the New Year. Jacob Gaffney is the editor of HousingWire. Write to him.