Prepayment penalties, which went out of fashion in the Eighties, are being re-evaluated by an industry facing its third refinancing wave in recent years. Putting surging mortgage activity in perspective (an estimated 45% of which is thought to be refinancing), Brian Smith, director of policy and economic research for America's Community Bankers, says, "A lot of our members are reporting that their pipelines in January had as many applications in a week as they had in a month during 1997."
Prepayment penalties won't help lenders whose mortgages currently are prepaying, because a penalty not in the original loan agreement cannot be added in retrospect, says Paul Smith, senior federal administrative counsel at ABA. However, on a home-equity line of credit, where the borrower hasn't used the full credit available, a lender might be able to apply a prepayment penalty, in much the same way that a credit-card issuer can change the terms of the credit, Smith says.
Investors want penalties
Many subprime loans are facing their first refinance opportunity, considering that the subprime market began to flourish when conventional mortgage lending dried up in 1994. Where once subprime loans were regarded as less sensitive to interest rates because applicants had few opportunities to refinance, now there is so much competition among subprime lenders that's no longer true.
The revenue from subprime loans is higher than that for conventlonals because subprime mortgage holders pay substantially higher interest rates.Consequently, secondary-market investors pay a premium for subprime loans-and many are starting to require prepayment penalties as protection of their investment.
In the booming 125% LTV niche (see last month's Mortgage Lending), investors are paying between 106% and 108%, versus par for the paper, assuming that they will receive the higher yield for long enough to justify paying a premium. Subprime paper generally is reported to be fetching between 103% and 106%.
What one thrift executive calls "asset evaporation" is also an issue forlenders holding subprime mortgages. This refinancing wave is the first to be affected by an accounting rule (FAS 122) that requires the institution to book the anticipated servicing value as an asset. (Many of the recently publicized downward revisions of earnings by subprime players reflect paper losses on such servicing.)
John Goga, director of acquisitions with Amresco Residential Credit Corp., an Ontario, Calif., acquirer of subprime paper, said, "For us, prepayment penalties often have as much value as the coupon." Goga was speaking in a session at the ACB/ABA Secondary Mortgage Conference, at which Andrew MacDonald, director of correspondent business at IMC Mortgage Company, Tampa, observed, "There's a lot of churning of subprime."
Goga said, "Our correspondent pricing for subprime loans assumes a three-year prepayment penalty."
On 125s, Charter One Bank, a Cleveland thrift, imposes a penalty of 4% of the loan amount for a loan prepaid in the first year, falling to a penalty of 1% for a loan prepaid in the third. …