Despite the sudden 50-basis-point back-up in rates, MBS analysts early last week were still expecting a significant increase in prepayments for the short-term.

According to a Lehman Brothers report, prepayments in October were reflective of mortgage rates between 6.75% and 6.85%, depending on the seasoning of the collateral.

In comparison, said Lehman, mortgage rates closed at 6.65% on Thursday, Nov. 15.

"More importantly, from a short-term perspective, the mortgage rate has averaged 6.35% over the past four weeks and the resultant surge in refinance applications will show up as paydowns over the next few months," Lehman added.

Two issues in question

Indeed, with the fast-changing mortgage rates, the short-term prepayment outlook is difficult to pin down, as two crucial factors are still in question. According to Lehman, the first question relates to what the effective mortgage rate is, while the second relates to the extent to which mortgage bankers are capacity-constrained.

Lehman's model uses a mortgage rate based on MBS prices. However, a problem arises because secondary mortgage rates have come down more than primary rates have.

The big question is whether the effective rate offered to consumers is running in tandem with secondary mortgage rates. Lehman disagrees with the common industry view that mortgage rates are "sticky."

"Sticky" primary rates mean that the mortgage banking industry as a whole is making unusually high profits per loan, Lehman says. "How could this be? Collusion among lenders seems unlikely in an industry where the top ten originators control less than 50% of origination." Lehman also questions why lenders would choose to collude only in a rate rally.

The analysts also disagree with the argument that the sharp rise in applications has caused a back-up in the mortgage banking industry, which has supposedly hindered lenders from lowering rates further. This is presumably done to curb demand.

Lehman believes that the impact of industry capacity constraints will merely be to shift the prepayment volume by a couple of weeks.

"The point is that since the industry has already adjusted to the high level of prepayments seen earlier this year, the proportional increase in volume is not as large as would have been had rates fallen instantaneously to current levels," said Lehman. "Based on the prepayment experience in these high ratio periods, we estimate that the average application processing period will extend by two weeks from the usual five weeks. This will shift the prepayment peaks on most unseasoned collateral to December."

Fast speeds willcarry on to the new year

According to a Countrywide Securities report, the back-up in rates should not have an immediate impact on industry capacity. Analysts said that a significant number of new applications are still being processed through the pipeline. This is why Countrywide is expecting the prepayment cycle to be extended, with accelerated speeds likely to continue into the new year despite the recent increase in market rates.

Analysts said that once the current flood of applications goes through the pipeline, they are predicting a downward pressure on mortgage rates compared to other market levels. Countrywide said that the trending down of mortgage rates will occur as originators try to maintain application volume and market share by offering competitive rates so that they would be able to make use of the additional capacity added throughout the next year. This lowering in rates, said the analysts, will likely become apparent early next year, as mortgage bankers work through the recent glut of applications.

Other analysts believe that the market has seen the peak of the refinacing wave in terms of applications. However, in terms of actual prepays, the peak is expected to happen in early 2002 with these higher rates, barring another sharp decline in mortgage rates.

"While primary market mortgage rates of 6.75% or higher will sharply curtail refinancing activity, fast speeds for the next three months are already in the pipeline," said Art Frank, head of MBS research at Nomura Securities. "Not until February do we expect a major slowdown due to the recent rate rise."

Meanwhile, as of press time last Tuesday, analysts were expecting only a modest decline in the MBA Refinancing Index that was due to come out Wednesday last week.

However, the significant declines were expected for this week .

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