Once again the fear in the MBS market is the possibility of a government refinancing program —dubbed refinance.gov or refi.gov by analysts — as a way to stimulate the economy.

Headlines have been rampant, although there has been nothing explicitly forthcoming from the Obama administration or Congress. One thing that most analysts agree on, however, is that it is very unlikely that any legislation will be passed. What is seen as more likely are regulatory changes that do not require the approval of Congress.

These changes include reducing or eliminating loan-level pricing adjustments (LLPAs); expanding the Home Affordable Refinance Program (HARP) by allowing multiple HARP refinancings and/or including post-June 2009 originations; and removing the 125% LTV HARP limit. For the most part, however, these changes would probably not help many borrowers underlying the super-premium coupons (5.5% and higher) but would mostly benefit those underlying 4.5s and 5.0s.

To help the higher coupon borrowers refinance, Nomura Securities MBS analysts said that put-back risk needs to be removed, which is deemed unlikely.

In research, Morgan Stanley analysts pointed out that removing put-back risk is problematic from a political perspective, especially as the GSEs' regulator, the Federal Housing Finance Agency, would have to answer to Congress for this.

Minimal Impact Seen on LLPA Changes

According to Deutsche Bank Securities analysts, removing or reducing LLPAs seems "both plausible and likely to raise MBS prepayments by an appreciable amount."

Their regression analysis suggested that a total elimination of fees would have the largest impact on 5% coupons at a 12 CPR increase in speeds, while 5.5s and 6s are limited to a 7 and 3.4 CPR gain.

"In total, reducing or removing LLPAs should raise prepayment speeds by only 1 CPR to 2 CPR across the aggregate 30-year market," they said.

Barclays Capital analysts said that "LLPAs are not the major impediment to refinancing; hence, eliminating them is unlikely to have any significant impact, especially for high-WAC credit-impaired borrowers."

They noted that under the HARP program, LLPAs and adverse delivery charges are capped at two points, which translates into mortgage rates approximately 33 basis points higher for the worst credit borrowers, or those backing super premium coupons, which are already in the money by around +/-200 basis points. Meanwhile, JPMorgan Securities pointed out that there are "second-order effects" caused by implementing a mass refinancing program - higher mortgage rates.

For example, they calculated that reducing upfront costs (similar to eliminating certain LLPAs) by 50 basis points would raise mortgage rates for the par coupon by 10-15 basis points. Mortgage rates would be further pressured, they added, by widening associated with increased supply.

Expanding HARP

Expanding HARP to remove the origination date restriction is seen as the easiest option, according to Nomura analysts. While this would not help the high coupon borrowers, they acknowledged, it would result in borrowers underlying 4% to 5% coupons having more discretionary spending dollars available.

Barclays analysts estimated that the impact of removing the eligibility date on one-year speeds on 2010 5s would be an increase to 24 CPR from 17 CPR and to 23 CPR from 17 CPR on 2010 4.5s. Annual savings from refinancings, however, are relatively limited at about $5 billion, JPMorgan analysts said.

Allowing multiple HARP modifications to occur is also an option. However, JPMorgan analysts pointed out that this would hurt originators' profits from selling MHA pools at a pay-up, and it would clog up the pipeline with borrowers who are continuing to refinance to take advantage of additional savings.

Several "HARP-ings" would also have very little impact on the housing market and the economy, said Deutsche Bank analysts, while potentially having a sizeable impact on valuations of 2009 and 2010 4.5s and 5.0s.

Removing the 125% LTV cap on HARP loans is also is perceived as having a limited impact that Barclays analysts calculated will be a maximum of 5 CPR.


Risks vs. Rewards?

The government, of course, is scrambling for ways to get the economy and jobs market growing again, and recovery of the housing market is seen as essential.

Finding the right balance between the cost and benefits, however, has proven to be daunting. "The amount of money that refinancing can save is relatively small in the grand scheme of things," said JPMorgan's MBS analysts.

For example, refinancing all borrowers to a 4.25% rate is about $30 billion a year, with $25 billion coming from pre-May 2007 originations that are already covered by HARP, they said in their report. Analysts added that this is an upper bound because the actual pull-through rate would be less than 100%.

Depending on how aggressive the government chooses to be, its reported refinancing initiative could have an adverse impact in the future of mortgage lending and result in higher mortgage rates for borrowers as investors demand more for the uncertain risk of government manipulation.


Avoid the Middle

The most likely changes from this possible government program, as discussed above, have the largest impact on 4.5% and 5.0% coupons. As a result, JPMorgan recommended an underweight to these coupons, while favoring an overweight to 5.5s through 6.5s due to the protection from the reps and warranty issue (put-backs). They are neutral on 3.5s and 4.0s.

Barclays analysts, however, favor FNCL 4s. While they think the government refinancing risk has been priced into the market, "as uncertainty looks set to persist until President Obama unveils new economic initiatives, we recommend a down-in-coupon bias and would avoid taking substantial premium risk in the near term."


Prepayment Outlook

The August prepayment reports that will be released on Sept. 7 should be uneventful for the MBS market, as they will not reflect the sharp drop in mortgage rates that has occurred through August.

Speeds are expected to increase between 8% and 10% on average from July levels for 30-year conventional MBS, with the largest percentage increases in the 4.0% and 4.5% coupons.

The primary factors are two extra collection days (23 versus 21). Refinancing activity in July was essentially flat on average versus June given that mortgage rates were static.

Paydowns are estimated at $79 billion compared to $72 billion in July, while net issuance looks to be essentially flat as gross issuance in August totals around $78 billion.

At this time and under the current regulatory and legislative environment, speeds are expected to steadily rise with peaks seen in October or November. This activity will be reported in November and December, respectively.

September speeds are expected to increase another 8% to 10% in response to a 40+% average rise in refinancing activity in August as mortgage rates averaged nearly 30 basis points lower. The factor that partially offsets this is a lower day count of 21 days in September versus 23 days in August.

By October, speeds on 2010, 2009 and 2008 vintage FNMA 4.5s are projected at 20, 27 and 35 CPR, respectively, up between 94% and 150% from July's levels.

Similar vintage 5% coupons are expected to prepay at 19, 25 and 33 CPR, between 43% and 90% higher from July. Compared with the November 2010 peaks, CPRs on 2010 and 2009 vintage 4.5s look to more or less match as the underlying borrowers get their first real opportunity to refinance, while 2008s are expected to prepay at 75% of their high. The 2010 5s should prepay slightly faster, while 2009 and 2008 are projected at between 76% and 87% of their 2010 peak.

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