Capacity constraints at mortgage lenders have dampened the number of refinancings that are able to get through the system. Current origination capacity at these firms can handle a refinancing index at only the 5000 level, Barclays Capital analysts said in a recent report.

Indeed, this seems to be the case. After hitting a record high for the year of 5085 in the week ending Aug. 27 when mortgage rates fell to a record low of 4.32%, the Mortgage Bankers Association (MBA) Refinance Index steadily declined for the next five weeks to 4181. The index surged back to 5060 in the week ending Oct. 8 in response to a new record low of 4.19%, but dropped more than 11% the following week.

In addition to the refinancing response, the recent widening in the primary-secondary spreads is another indicator of ongoing capacity constraints at the mortgage lenders. Morgan Stanley analysts recently reported that the spread is currently at a cyclical high of around 130 basis points, up from the 80 basis points area in mid-spring 2010.

Previously, MBS many analysts were anticipating some degree of narrowing in the spread since originators have been in the process of expanding capacity. Morgan Stanley analysts, however, believe that the primary-secondary spread might not tighten much despite the easing in capacity constraints. Instead, they expect that the rising costs for servicers related to foreclosures and increased pressure to reduce put-backs could keep the spread on the wider side.

Mortgage bankers said that they are rejecting some Fannie Mae Delegated Underwriting and Servicing or DUS products and Freddie Mac Loan Prospector loans because of concerns over put-backs, according to a news brief on a panel at the MBA annual convention held last week in Atlanta. A banker specifically noted that his company was spending a considerable amount of capital and time to deal with these issues. This remark implied that the Refinance Index could remain capped at the 5000 area.


Limited Impact on Prepays

The latest crisis to hit the housing market - the suspension of foreclosures because of issues related to foreclosure documentation - is expected to have only a limited effect on agency MBS. Foreclosures have no direct impact since the GSEs take out loans from pools when they become 120-days delinquent, which is before the foreclosure process begins.

Credit Suisse analysts said that voluntary prepayments could decline slightly if enough title insurers delay or refuse to insure previously foreclosed properties. If the issue drags on and originator/servicers have to divert resources to deal with the foreclosure issues, analysts expect this would increase closing lags on new originations and increase mortgage rates because of the widening in primary/secondary spreads, a factor that would slow prepayments and originations.

JPMorgan Securities analysts added that the issues reinforce the impact of the tighter underwriting standards, which could slow speeds further.


Prepay Outlook

The current prepayment outlook into yearend has aggregate speeds flat to slightly higher with the lowest and less seasoned coupons recording the largest percentage increases resulting from strong FICOs and LTVs, while credit impairment continues to dampen higher coupons. Deutsche Bank Securities Head of Securitization and MBS Research Steven Abrahams also expects this pace to pick up into the end of the year, with 2009 FN 4.5s' speeds increasing to more than 30CPR by November (reported in December) from 22CPR in September, and 2008 5s nearing 50CPR from 42CPR. Market consensus has the coupons and vintages prepaying at 28CPR and 46CPR in December, which will be reported in January.

This is in response to lower mortgage rates and a pickup in refinancing activity that has occurred this fall. The 30-year fixed mortgage rates have averaged 4.22% month-to-date through Oct. 22. This is down from 4.35% in September, based on Freddie Mac's weekly survey. Meanwhile, the MBA's Refinance Index has averaged nearly 7% higher to the 4700 area.

On aggregate over the next three prepayment reports for 4% through 7% coupons, speeds are projected to increase around 4% in October, hold flat in November, and increase 3% in December. Overall, the increases are rather modest considering current mortgage rate levels.

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