Lessons from CFOs: When Refinancing Makes Sense

When Fortune 500 CFOs consider whether to refund corporate bonds, they typically ask two questions:

• How much can we save by refunding today?
• Is that enough, or should we wait for more savings?

One question I am pretty sure they don’t ask: What’s the payback period?

And yet that’s the metric many advisers quote to homeowners when considering whether to recommend a refinancing — the number of years it takes to recover transaction costs with lower payments.

While payback is easy to calculate and seems sensible, there are reasons fixed-income specialists don’t use it. One is that payback treats a mortgage like an ordinary bond and completely ignores the option value.

Professionals who trade mortgage securities learned years ago what a bad bet that can be. Simply “dumbing down” a mortgage doesn’t work. You have to do the more complicated task of accounting for the lower payments that result when a mortgage holder exercises the option to refinance.

Wall Street banks and other institutional bond managers have the tools to handle this calculation. And while their tools are sophisticated, what they do is fairly straightforward: They value the refinancing option and then factor that into the mortgage pricing.

Besides being useful to traders, this valuation tool also provides a useful benchmark to CFOs. They can now verify how much of the refinancing option value they are capturing and therefore whether a refinancing is worthwhile.

The actual benchmark is known as “refunding efficiency.” It is an industry metric that measures the ratio of today’s refinancing savings divided by the refinance option value. A high score — up to 100% — indicates a “go” recommendation, while a lower score is a signal to wait for more savings.

Refunding efficiency was introduced by Andy Kalotay, a Wall Street quantitative analyst and former director at Salomon Brothers. Kalotay has adapted the technology to the consumer mortgage market with the Kalotay Refi Score. The score works the same as refunding efficiency by calculating a ratio that can range between 0%–100% which lets the homeowner know whether to refinance now or wait.

For example, you can run the calculation on an existing $100,000 mortgage at 5% interest and check whether refinancing at 4.7% is recommended. Factoring in 1.5% transaction costs, today’s refinancing savings are $1,804, but the refinance option value is $2,045. The resulting refi score of 88.2% is below the desired threshold, so waiting is probably the best advice.

Bottom line, the refi score gives advisers the same technology that CFO’s use when pursuing a disciplined strategy for harvesting refunding savings on corporate bonds.

How would an adviser explain the idea of a refinancing score to a client?

In the simplest scenario, the choice is whether to refinance today or tomorrow. First, you can calculate today’s refinancing savings — the value of keeping the existing mortgage, the value of the new mortgage, and all transaction costs. And while nobody knows with absolute certainty tomorrow’s refinancing savings, you can model them by making an educated guess based on the behavior of the particular interest rates.

Second, you can take tomorrow’s estimated refinancing savings, discount that amount back to today, and compare it to today’s refinancing savings. The higher of the two amounts is the estimated maximum savings and also the value of the refinancing option. From there it’s easy to see, for example, that the refi score can never exceed 100%.

The refinancing tool can also show why expected savings don’t depend on a prediction of lower mortgage rates. In fact, the model assumes that rates tend to stay the same on average. Savings come from the up-and-down movements of rates and the fact that the option structure zeros out avoidable refinancing losses.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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