Mortgage Woes May Point toward New Rate Rally

These days, the focus on interest rate risk that predominated during the peak years of the refinancing boom has given way to a renewed emphasis on credit risk. Most portfolio managers have been plagued by questions regarding early payment defaults, payment shock on ARM loans and the valuation of residual interests in securitized loans.

But that doesn't mean interest rate risk is fading from view. To the contrary, the recent woes in the mortgage sector could portend yet another rate rally, which could inspire renewed refinancing and portfolio runoff.

The conundrum facing the industry is that the very moves -- widely advocated among some economists -- that would be designed to ease the housing industry's credit woes would likely spur renewed refinancing. Already, the Federal Reserve board has been urged to lower short-term interest rates in order to spur economic growth and ease the burden of payment shock on the millions of home loan customers who face rate resets.

Additionally, on a broader level, there is growing concern that the housing downturn could morph into an economic recession, and that also - like previous economic slowdowns - would likely portend lower mortgage rates and increased refinancing.

Whether or not a recession is in the offing is anybody's guess, but most economists have turned bearish on the prospects for a housing recovery in the short term.

The Mortgage Bankers Association now predicts that home sales won't begin to recover until "the second or third quarter of next year." Moreover, the MBA says in its most recent housing and mortgage outlook that a projected Fed easing may help the liquidity crunch, especially for prime quality borrowers.

The MBA projects that loan originations to refinance an existing loan will fall by 14% to a total of $1.17 trillion this year. While the tightening of underwriting standards in the subprime sector may curtail volume in the subprime sector, the MBA expects that the Fed's moves to restore liquidity to the financial markets will support refinancing activity in the prime mortgage sector. The MBA projects that both home purchase and refinancing volume will decline again in 2008.

But it's not hard to see a scenario in which refinancing - and portfolio runoff - will increase at a rate fast enough to impair the value of mortgage servicing rights. Either a significant recession or aggressive Fed easy would almost guarantee that interest rates would fall low enough to spark a refinancing boom.

And even ignoring those doomsday scenarios, the market could favor refinancing activity that exceeds expectations.

Here's one scenario: A slowdown - not a recession - but a general slowdown results in an easing of long-term mortgage rates. People with adjustable-rate loans all of a sudden find fixed-rate alternatives attractive. And even existing fixed-rate borrowers may find themselves on the cusp of making a move if rates go low enough. In recent weeks, the MBA's weekly survey of loan applications has seen refinancing account for about 40% of loan applications, a level still relatively high by historical standards.

So while today's focus is on credit risk management, this is no time to forget about interest rate risk. In fact, the steps being taken to mitigate credit risk may leave the industry facing renewed rate risk. (c) 2007 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com http://www.sourcemedia.com/