Conditional Prepayment Rate And mREITs

Includes: AGNC, ANH, NLY, WMC
by: Dividend Living

Mortgage Real Estate Investment Trusts or mREITs report Conditional Prepayment Rates (CPR) every quarter in their earnings report. During 4Q 2012 they ranged from 26% ((NYSE:ANH)) to 3.6% ((NYSE:WMC)). This metric has a big impact on returns and can mean the difference between a 16% dividend and a 10% dividend. This article will attempt to explain what the CPR is and how the mREITs take steps to lower their CPR.

CPR is a measure of the percentage of mortgage assets owned by the mREIT that was refinanced or paid off early on an annualized basis. What this means to the mREIT is that they get their money back for the mortgage they bought but they don't receive the interest they were expecting. This cash now has to be re-invested at the current interest rate, which may be lower than the interest rate they had been receiving. There is also the interest lost during turnover time, or the time between the prepay and when the money is re-invested. mREITs make money on the interest they receive from the mortgages they own. Having a mortgage prepay can hurt the bottom line by reducing the interest earned. Agency MBS are bought at a premium and a prepayment will result in lost money as they will be repaid at par value. Non-agency MBS acquire securities at a discount to their par. Because of this, prepayments may actually help non-agency mREITs (Source), although they have to deal with turnover time loss and will have to re-invest their capital at the current rates. Non-agency MBS also have default risk, which is when the mortgage is not paid back.

When a borrower of an Agency backed mortgage does not pay their mortgage for 120 days, the Agency buys out the mortgage resulting in a prepay of the mortgage. Refinancing of mortgages by homeowners to receive a lower rate of interest also results in a prepay. When interest rates on mortgages are going up, CPR will lower due to less refinancing. An improving economy reduces foreclosures.

The steps mREITs take to lower their CPR is to choose Mortgage Backed Securities (MBS) that fall into these categories:

Lower Loan Balance: Loans with low principle left tend to not prepay as often because the costs of refinancing are greater than the money that would be saved at the lower interest rates.

High Loan to Value (LTV): LTV is the ratio of the mortgage price to the total appraised value of the Home. Higher LTV ratios are primarily reserved for borrowers with higher credit scores and a satisfactory mortgage history. These borrowers are less likely to default which results in a prepay of the agency backed mortgage.

Already having gone through Make Home Affordable (MHA) program or Home Affordable Refinancing Program (HARP): (this is often combined with LTV) Loans that have already gone through these government programs and have a high LTV are less likely to default.

Low Weighted Average Loan Age (WALA): WALA is the average number of months since the date of note origination of all the loans in a pool weighted by remaining principle balance. Loans that recently were given out have less chance of default.

Lower Third Party Originator Loans (TPO): TPO loans are originated by someone other than the actual mortgage lender. Third Parties do not have responsibility for the performance of the mortgage whereas the actual lender is subject to some recourse if the mortgage defaults. TPO loans undergo less scrutiny because of this and are more likely to default.

Investor Loans: Mortgages given to investors have less chance of prepay.

Low FICO Score Loans: When a borrower loans to someone with a low FICO score, more diligence is taken to assure a compelling argument for why they would be able to make their payments consistently and on time in the future. This leads to lower defaults. Source

The table below compares the CPR rates of WMC, AGNC, and NLY and how it effects their spreads and yield.

CPR Spread Leverage Yield
NLY 19% .95 6.5 11.76
AGNC 10% 1.63 6.7 15.25
WMC 3.6% 2.05 9.1 16.35

WMC chooses mortgages using all the strategies above and has the lowest CPR among mREITs and also the highest yield. As WMC pointed out in their earnings presentation, lower CPR rates increase the yields, the spreads, and the returns even if you are paying slightly more for the MBS. Their 4Q reported allocation is 50% lower loan balance, 35% already gone through MHA/HARP with high LTV, 13% low WALA and low % TPO, and 2% investor and low FICO score loans. The WALA for the portfolio was 7.1 months. As stated in their earnings report "We believe that managing our WALA is a key component toward keeping our prepayments low."

AGNC 4Q reported allocation is 46% lower loan balance, 32% already gone through HARP with high LTV, 21% with WALA of under 3 years, and 1% of older loans with a higher CPR.

NLY's fixed rate securities: 91% not subject to HARP and its also broken down by category: 54% are generic MBS, 11.5% are low loan balance, 17.3% high LTV, 5% are investor owned, 10.5% are jumbo conforming loans, which have a high CPR (38%). The size of their generic MBS and jumbo conforming holdings raises their CPR to one of the highest in the mREIT space. NLY CPR numbers are broken down here.

Rising Mortgage Rates

Interest rates on mortgages are rising. As of the 11th of March, the 30 year mortgage rate was at 3.7 compared to 3.4 on the 1st of January. This will effect CPR by lowering the amount of refinancing. If the jobless rate and economy continue to improve, defaults will decrease as well, which will lower CPR even further. If a prepayment happens when there are rising mortgage rates, the money can be reinvested at possibly higher rates of return. Rising rates are good news for CPR reduction and I would expect CPR rates to lower in the 1Q 2013 earnings reports. There are other factors to consider with rising rates, such as its effect on book value and spreads. Book value tends to go down with rising rates as the mortgages with the lower rates that mREITs hold are worth less. Spreads increase with rising mortgage rates (as long as the short term borrowing remains the same, which the FED is making sure of at the moment) and that means more income for mREITs and more stable and possibly higher dividends.

Fannie Mae Agency monthly CPR rates can be found here.

Disclosure: I am long WMC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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