These events could represent a perfect storm for mortgage-backed securities (MBS). That’s because there’s an embedded pre-payment option within a mortgage loan. Indeed, pre-payment risk management is one of the most important factors with which investors concern themselves when they value these securities. All things equal, if a buyer believes that volatility is going to increase, there's an off-setting downward effect to the price that he’s willing to pay. When volatility rises, the call option that the MBS investor has sold to the mortgage borrower (via the ability to pre-pay) is worth more, thus reducing the value of the security.

Timing is everything. All fixed income investors - but MBS investors in particular - seek stable and predictable cashflows. If the Fed decides to become aggressive and cut rates faster than expected, it could trigger what’s known as a “refi wave”. That’s when people pre-pay their mortgages en masse during a relatively short time period. All that pre-payment activity during a relatively short amount of time can create disruption. In the capital markets, new issuance rises as older bonds are retired either partially or in full, leaving investors flush with principal that needs to seek reinvestment opportunities.

On the borrower-facing side, originators must manage substantially higher loan application volumes as they contend with industry capacity constraints related to staffing. At the same time, servicers are tasked with hedging their book of business against a fast-moving target to preserve fleeting value. Conversely, a more patient Fed that leads to fewer rate cuts or a slower pace of cuts can be problematic. In this scenario investors might see the repayment periods extend for their MBS holdings relative to expectations. Lenders might see more muted rate lock activity as borrowers await lower rates, and real estate markets may remain grid-locked for longer.

At ICE, we can use our McDash dataset to estimate where thresholds of pent-up activity might be lying in wait for an opportunity to refinance should the chance arise. As of our August Mortgage Market Monitor report, there were 4.2 million borrowers with recently originated high interest mortgages (>=6.5%). It is likely that at least a portion of them is angling for a window to open so they can re-finance. That’s good news for borrowers because it enables them to pay less money to their mortgage every month and presumably save or allocate the money elsewhere. That kind of consumer spending can give the economy a boost. Homes sales might increase as well, should more inventory come onto the market if borrowers with low mortgage rates feel less of a “golden handcuff” mentality.

Of course, the Fed’s decision to drop interest rates is not done in a vacuum but as a way to implement intended changes to monetary policy. They lower rates because they decide that the economy needs some stimulus, so their decision to ease could come with a certain amount of economic pain. Maybe unemployment goes up, manufacturing stalls, or GDP growth slows down. The Fed might then think present rates are too restrictive and take a more accommodative stance toward monetary policy. Resulting lower rates could help stave off delinquencies and ultimately foreclosures.