Home Price Drop Could Slow Refi Boom

As the market was heading into the first-quarter earnings season, most analysts were pessimistic about bank and thrift prospects. An analyst at Goldman Sachs even went so far as to suggest that investors might want to sell Washington Mutual shares short, just days after WaMu said that it was raising new capital.

The main thrust behind the negative sentiment is an expectation that credit losses will remain elevated, wiping out profits not only at WaMu but at many other lenders as well. But unfortunately, most companies aren't likely to get much of a boost from the value of their servicing rights, unless they experience another quarter of "hedging outperformance." That outperformance, which suggests financial derivatives purchased to hedge against the impact that falling interest rates have on MSR values, comes with a catch, however. Outperformance essentially indicates that a company misfired, overestimating how much a decline in rates would reduce their servicing value. But if your aim is off, who knows if the next misfire might result in hedging "underperformance"?

Leaving that question aside, interest rate economics haven't been all that favorable for MSR investors during the first quarter.

To be sure, mortgage rates did not fluctuate widely during the first quarter, but the waters were a bit choppy, with the average 30-year fixed-rate mortgage coupon going as high as 6.24% in late February and as low as 5.48% in late January, according to Freddie Mac's weekly conforming mortgage rate survey. At the start of the quarter, the average 30-year rate was just over 6%. At the end of March, the average had slipped to 5.85%. That might not yield huge impairment for companies that still account for their MSR asset that way, but it is enough to raise worries about another refinancing surge.

Refinancing has accounted for just over half of new home loan applications in recent weeks, according to the Mortgage Bankers Association. In the last weeks of March, refinancing actually exceeded the 60% level.

While that may not approach the boom levels seen in late 2003, it is a tipping point that suggests that mortgage servicers will have to manage an increase in portfolio churning and runoff at the same time they face rising servicing costs related to higher delinquency rates.

With the economy slowing, there doesn't appear to be any imminent reason to expect rates will go up. But the housing recession and the subprime meltdown have added a new wrinkle to analyzing prepayment trends in the mortgage industry.

Because lenders and the secondary market agencies have tightened underwriting standards, not everyone who has a loan they'd like to ditch can qualify for a new, conforming mortgage loan. As for the nonconforming market, everyone predicts it will come back eventually, but financing for the subprime sector has pretty much dried up for the time being. Both Standard & Poor's and OFHEO reported that home prices continued to decline in January, according to their data, and that isn't going to boost the industry's confidence in the stability of collateral values.

Because qualifying for a mortgage loan has become more difficult, refinancing activity may be slower than it had been in similar rate environments in the past. But even if that leads to hedging outperformance, one has to ask at what price for the industry overall?

Time will tell what impact the subprime mess has on the behavior of mortgage borrowers. But certainly today's landscape looks different from what we have become accustomed to in recent years. Perhaps prepayment speeds will be slower as rates edge downward. Then again, maybe this is just a temporary phenomena, and we'll all be surprised when lenders once again begin to extend credit a little more liberally and prepayment rates migrate back toward historical norms.

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