Rate Forecast Calls for Cautious Optimism

For portfolio managers, the present economic environment is a lot more reassuring than the meltdown in mortgage rates that generated huge volumes of refinancing between 2002 and 2004. But that doesn't mean people responsible for hedging mortgage portfolios can take their eye off the ball.

A number of factors point toward elevated levels of refinancing - and portfolio runoff - even as interest rates edge upward. The rise in popularity of hybrid fixed-adjustable products, plus the latest innovations in option ARM products and interest-only loans, mean that many borrowers are facing upward adjustments in their monthly mortgage bills. In some cases, those adjustments could lead to dramatically higher payments. Some of those borrowers will respond by refinancing into a new loan product, creating new challenges for hedge managers as they study the prepayment characteristics of these new loans.

And even for more traditional fixed-rate products, hedging may gradually be growing more complicated. Borrowers enter the next rate cycle with more experience and knowledge about refinancing than ever before, and that may mean that they'll be quicker to pull the trigger when a rate incentive to refinance emerges. In addition, cash-out refinancing reached its highest level since 1990 in the second quarter of this year, with 88% of refinanced loans resulting in new loans at least 5% higher than the original balance, according to Freddie Mac. While home price growth may be slowing, many homeowners still are sitting on substantial equity, which may prod them to refinance to consolidate debt or access cash.

On the bright side, interest rates seem to be stabilizing with a bias on the upward side, suggesting that rate-induced refinancing should cool down. Freddie Mac chief economist Frank Nothaft predicts that rates will fluctuate within the 6.5% to 7% range for the rest of this year. He believes that cooling housing markets and weaker consumer confidence have raised hopes that inflation will remain in check, helping to let some steam out of the pressure for higher rates. At the end of August, 30-year mortgage rates were about 40 basis points below their peak in July. ARM rates were also lower.

Economists at the Mortgage Bankers Association and Fannie Mae also foresee interplay between cooling housing markets and slightly higher mortgage rates in the near future. The MBA noted that while home sales have been cooling, refinancing edged up as the average rate on 30-year, fixed-rate home loans dipped by 15 basis points in late August. Economic data in August suggested some economic slowing, boosting confidence that the Fed will hold interest rates constant. That brought the yield down on 10-year Treasuries to the lowest level since March, a factor that contributed to lower mortgage rates last month.

But not everyone thinks that lower mortgage rates will last. In fact, most housing economists expect rates to edge upward.

Fannie Mae chief economist David Berson, writing in a recent monthly economic overview, noted that while the economy has been cooling, core inflation increased by 2.5% in the 12-month period ending in June.

"Core inflation has moved up yet again and it is above the likely upper end of the Fed's implicit target range," he said. That could augur for further rate increases.

Meanwhile, it's not all dark clouds for the mortgage industry. Despite a cooling housing market, mortgage financing remains brisk. Mr. Berson predicts that mortgage debt outstanding will grow by just over 10% this year, with home-equity lending and cash-out refinancing helping to offset the decline in home purchase lending and slower home price appreciation. (c) 2006 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com http://www.sourcemedia.com