Mortgage Retention: Predicting Refinance Motivations

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1 Mortgage Retention: Predicting Refinance Motivations Nothing endures but change - Heraclitus (540 BC 480 BC) Changing Trends in the Mortgage Industry In 2001, at the dawn of the new millennium, long term and short-term mortgage interest rates were falling. By 2003, a booming economy, coupled with low interest rates and buoyant customer confidence, was pushing up house prices. As you can see in the table below, the refinancing share of mortgage originations hit a high of 65% in TABLE 1: US ECONOMIC AND MORTGAGE INDICATORS Major Economic & Mortgage Market Indicators * 2008* A Real GDP (%) B Consumer Prices (%) C Unemployment Rate (%) D 30-Year Fixed Mtg. Rate (%) E 1-Year Treasury Indexed ARM Rate(%) F 10-Year Constant Maturity Treas. Rate (%) G 1-Year Constant Maturity Treas. Rate (%) H Housing Starts (Millions of housing units) I Total Home Sales (Millions of housing units) J House Price Appreciation (%) K Total 1-4 Family Mortgage Orig. ($ Billions) 2,883 3,860 2,911 3,250 2,651 2,495 2,395 K1 Conventional 2,697 3,630 2,776 3,167 2,571 2,395 2,275 K2 FHA & VA L ARM Share (%) M Refinancing Share (%) N Growth of Residential Mortgage Debt (%) * Forecasted figures Source: Freddie Mac Economic and Housing Outlook Continued low interest rates in saw home prices grow more than 10%. This increase was also fuelled by widespread speculative demand in real estate. The housing and mortgage boom continued in with products like Option ARMs, Interest only loans, and no down-payment loans, which offered customers the ability to afford houses well beyond their means. Rising inflation

2 caused the Fed to start raising short-term interest rates in mid-2004, though the 30 yr FRM rates still remained low (see Fig. 1). The current economic scenario is vastly different from what we saw four years ago. Compared to 2003, both short-term and longterm mortgage rates have seen a substantial increase, while growth in house price has slowed down. Delinquencies and foreclosures are on the rise, with the rising interest rates stretching the mortgage debt burden, and deflation in house prices allowing fewer escape options. The mortgage market is experiencing a slow-down compared to the rapid pace three years ago. A sharp upswing in short-term mortgage rates has led to a significant decline in the number of customers looking to refinance. While purchase volume has seen a steady increase, the refinance share of the market has shrunk by more than 60% since it peaked in yr FRM Rate (%) 1 Month LIBOR ARM Rate (%) HPI Qtr-Qtr Growth Rate (%) Total 1-4 Family Mortgage Orig ($bn) Refi ($bn) Purchase ($bn) Refi Share (%) Refinance Motivations: Changing Perspectives 2003 was the year of Classic Savers. With more than 80% of the market still using FRM mortgage plans, most customers used this opportunity to refinance into a lower rate and reduce their monthly payments. ARM customers also saw this as an opportunity to lock in low rates for a longer period and hence, refinanced into FRM loans. The incentive of cashing out the built-up equity led many customers to refinance with a cash-out option. Refinance share reached an all-time high of 65% in 2003.

3 As house prices went up, consumers sought more affordable mortgage options. A slew of new products, like Interest Only Loans and Option ARMs came into the market to meet this need, and were lapped up by consumers. As we enter 2007, due to the previous unprecedented housing price boom, housing affordability is at record lows. The preceding borrowing frenzy has left consumers with historically record debt service burdens. In addition, with more adjustable rate mortgages, they are far more exposed to higher interest rates. Energy prices, although easing, are still higher than in the past. Refinance will be increasingly triggered by the expected payment shocks due to the impending ARM resets, and the need for customers to re-organize their debt and reduce their total monthly payment burden. Table 2 shows refinance predictors in rising and falling interest rate environments. TABLE 2: PREDICTORS FOR REFINANCE Predictor/Driver Rationale FALLING RISING Int. Rates Int. Rates CREDIT HUNGER Activity, Score, Utilization, Need for Debt Consolidation Balances (Home Equity, Credit Size of DSB Reduction Yes Yes Card, Auto) MORTGAGE Balance, Monthly Payment Size of Debt Service Burden Reduction Yes Yes RESETS Expiration of Teaser Rates, Payment Shocks No Yes Other Reset Triggers Affects Ability (vs. Desire or Need ) to HOME EQUITY consolidate Debt or take Cash Out Previous/Built-up (Mortgage Equity Withdrawal) Yes Yes PRODUCT FEATURES eg. Prepayment Penalty, Negative Amortization Affects cost of ReFi Yes Yes Refinance Motivations: Changing Product Perceptions - A Case Study The following observations are for a large, growing mortgage portfolio. Currently, on an average, a customer refinances his/her loan once in 4.5 years. Thus, for most customers there is hardly any difference between Fixed Rate Loans and Long ARM (7/1 or 10/1) products. The payoff rates are almost the same for both the product types, as seen in Table 3. As expected, as the fixed period of ARMs decreases (shorter ARMs), payoff rates rise.

4 TABLE 3: PAYOFF 1 AND RECAPTURE 2 INDICES Annualized Payoff Index Recapture Index FRM Long ARM Med ARM Short ARM( non-io) IO Short ARM Option ARM Payoff Index: Payoff Rate for the segment compared to the payoff rate for the portfolio 2 Recapture Index: Recapture Rate for the segment compared to the recapture rate for the portfolio Contrary to common perceptions, option ARMs do not have exceptionally high payoff rates. This is because most of these customers choose the minimum pay option which results in a payment that is fairly constant (with the exception of small annual increases) over a number of years. TABLE 4: PRODUCT MIGRATION INDICES 3 FRMs ARMs Option ARMs Option ARMs IO FRMs IO Long ARMs IO Med ARMs IO Short ARMs FRMs Long ARMs Med ARMs Short ARMs Product Migration Index: Ratio of the percentage of customers that refinance from one segment (e.g., Option ARMs) to a major segment (e.g. FRMs), compared to the percentage of customers that migrate to that segment on the portfolio level A look at product migration while refinancing (Table 4), tells us that there is a definite shift of customers from IO loans towards Option ARMs, which provide them with a lower payment option to manage their mortgage. As a case in point, new products such as the 5 yr Fixed MTA option ARM, allows the customers to make fixed minimum payments for the first 5 years of the mortgage, while the fixed interest rate for 5 years gives them an accurate picture of how much negative amortization they would incur in using the minimum payment option over these years. With interest rates rising, we also find that the majority of ARM customers move to FRM products, looking to secure the rate even though it might be higher than what they were paying. Most of these ARMs have their reset dates approaching, and their interest rate would adjust to a higher figure, if they were not refinanced now.

5 Thus, there is a definite polarization in the refinance market. While one set of customers are refinancing into FRMs to hedge against rising interest rates, another set, mostly customers who took IO ARMs is finding it difficult to maintain payments and hence is moving to Option ARMs to ease the burden temporarily. Another notable aspect is that Option ARMs customers show a marked polarization in their refinance method, with a sizeable percentage refinancing into FRMs, and almost half of them coming back to an Option ARM to enjoy the minimum payment option. (See Table 5) TABLE 5: OPTION ARMs PAYMENT BEHAVIOR Payment Options Payoff Recap Go To Product (Migration Indices) Index Index FRMs ARMs HE Option ARMs Amortization Only Mostly Amortization IO only Mostly IO Min Payment Only Mostly Min payment Customers making Amortizing payments Have higher pay off rates and lower recap rates Are more likely to refinance into a more conventional product. Typically, these customers did not understand the low pay rate feature of option ARMs and might have confused it with a low interest rate on the loan. When these customers receive their first statement they realize the difference and make amortizing payments to avoid negative amortization on their loan. These customers, thus, receive a payment shock every month that the index rate rises, and are very likely to payoff. Moreover, the recap rate is also low for such customers as they are not too happy with their current situation, especially if prepayment penalties are involved. On the other hand, customers who have understood the product, and are using the Min Payment option most of the time, have low payoff rates and are more likely to refinance back with the client. Mortgage Retention: Outlook for 2007 and Keys to Success The combined effect of falling house prices and increasing interest rates - especially for ARM resets, will lead to increasing delinquencies, foreclosures and write offs in More customers will face payment shocks with fewer options to recover. Credit standards will be tightened, further increasing the cost of a mortgage, especially for sub-prime customers, and we will see a further slow down in the mortgage market.

6 In such an environment, the key to retaining customers will be a comprehensive customer retention strategy which: Targets customers using innovative products customized to their need. For example, option- ARMs, which offer the choice of accelerating or slowing down the payment, Rate buy down products, especially the lender paid rate buy down products which can be used by the realtors as marketing incentives, and Choice products, which require less documentation, and are the only options in case of high LTV, low FICO, investor property, will be able to cater to the specific needs of a customer Has a Sales Team that is well-trained in these innovative products and their features and can provide the right guidance and hand-holding for customers looking for the best option for their mortgage needs. Uses Value Based Targeted Marketing Strategy to identify the basic pain and gain drivers for each customer and identifies the most valuable customers to target and retain. Our experience shows that 75% of the value can be captured in top 30% of customers, and using our predictive models, the value of a targeted customer is typically 4.5 times higher than the non-targeted customer Uses the right channels to target customers, with customized messages that address their particular need and intrinsic behavioral features, e.g. payment squeeze, cash out, nearing ARM resets. On existing customers, DM and OTM have generated lead rates to the tune of 4% and >10% respectively

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