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Duration Extending?

If the experts are right, then mortgage duration should begin extending again as interest rates edge upward this year.

Forecasting interest rate movements is always a dicey proposition, but most economists believe that economic growth is strengthening, and that should push rates in an upward direction. The Mortgage Bankers Association, for example, predicts that the average 30-year mortgage rate will hit 6.5% by the end of this year, up roughly 75 basis points from the level in mid-February.

At 6.5%, home purchase lending would account for 80% of the home loan market and refinancing would drop to 20% from a current level of about 50%, according to Dale Westoff, a prepayment expert at Bear Stearns.

In addition to putting a clamp on refinancing, higher rates would likely slow housing turnover, because some potential trade-up homebuyers would have trouble qualifying for financing as the cost of borrowing rises.

Those two factors, especially the drop in refinancing, will increase mortgage duration, Mr. Westoff told Mortgage Servicing News. But he predicts the extension of mortgage life cycles will be more modest than the market saw last summer, when rates went from a low of about 5.25% in June to over 6% two months later. At that time, the average mortgage duration jumped from less than a year to three-and-a-half years in a short time period according to prepayment models, Mr. Westoff said.

Today, a 50 basis point rise in rates would only cause an extension of the average mortgage life span by about six-tenths of one year, he said, resulting in a "much more orderly kind of move."

The reason that mortgage duration will move more modestly this time is that fewer loans are exposed to refinancing in the first place, he said. When rates hit 5.25% last summer, 75% of the outstanding universe of home loans were eligible to refinance and improve their rate and terms. In February, with rates hovering at about 5.75%, only about 45% of outstanding loans were vulnerable to refinancing.

If rates creep up to 6.25%, just 30% of loans would be eligible to refinance, he said. At 6.5%, the universe of exposed mortgages drops dramatically, with home purchase lending accounting for 80% of the loan origination market.

"So you are dealing with a much smaller universe of borrowers that even have the opportunity to refinance," Mr. Westoff said.

Another factor that affects mortgage duration is housing turnover, and Bear Stearns still expects the housing turnover rate to be strong this year. But rising rates could slow prepayments, and extend mortgage duration, in the home purchase market as well.

Rising rates could create a "lock-in" effect for homeowners who might otherwise be looking to move, making it more difficult for them to qualify for financing for a more expensive, trade-up home purchase, for example.

Arthur Frank, director of MBS research at Nomura Securities International, said that as duration is extending, MBS prices fall, hurting that absolute return rate of mortgages.

That forces the government-sponsored enterprises, hedge funds, and leveraged portfolios to adjust as the market sells. Often, they "shed duration" in the swaps market to rebalance assets and liabilities and keep their "duration gap" close to zero, he said.

"As mortgages extend, they do have to sell some duration."

Investors whose performance is measured against an index have less to worry about, since the index will likely exten its duration as well.

But Mr. Frank also said that just because there is a widespread expectation that rates will rise this year doesn't mean it will happen, noting that consensus predictions among economists have been wrong in the past.

"My 17 years in fixed-income research has taught me that interest rate direction is relatively difficult to predict," he said.

Other economists are also cautious about the outlook. Frank Nothaft, chief economist at Freddie Mac, said the Fed seems unlikely to raise short-term interest rates before the third or fourth quarter. Freddie Mac projects that the average 30-year, fixed-rate mortgage rate will be 6.0% at the end of this year.

"We see no inflationary pressure on the horizon," he said.

Mr. Nothaft is among a number of economists who believe that the "run rate" of refinancing in a stable or rising rate environment is likely to be higher than it has been in the past.

"We have been able to reduce some of the cost and uncertainty and time delay that occurs when families go through the application process," he said.

Steven Davidson, an economist at The Bond Market Association, also thinks that consumers may refinance more easily than in the past, even without a rate incentive - and that could reduce the increase in duration as rates rise.

He points out that economists have consistently underestimated the strength of the loan origination market during the past two years, and that mortgage rates edged downward rather than upward during much of January. With little evidence of inflation on the horizon, Mr. Davidson said any rate rise is likely to be gradual and more tranquil than if the market were responding to inflationary pressure.

"We are almost in uncharted waters," he said. "Interest rates are still the most significant factor determining the average duration, the average life of a mortgage."

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