Up until the market closed on Tuesday last week, the higher mortgage coupons were setting new price highs as the prepayment outlook remained fairly benign as a result of the U.S. borrowers' credit-impaired status.

On Wednesday, however, talk of a government-sponsored refinancing event shook the market and heavy selling in 5.5 through 6.5% coupons were triggered by prepayment fears.

While there have been periodic reports about a government-sponsored program, the catalyst appears to have been a report issued on Tuesday last week from Morgan Stanley economists.

The report suggested that the economy could receive a significant boost almost immediately and with no impact on the budget deficit "if the government merely recognized its existing guarantee on the principal value of a large part of the mortgage market - the mortgages that are backed by Fannie [Mae], Freddie [Mac] and Ginnie [Mae] - and acted to streamline the refi process."

The economists calculated the potential savings for borrowers who have not been able to refinance at around $46 billion per year, with the economy benefiting from the "powerful spending response" that the savings from a lower mortgage payment would generate.

"Wouldn't it seem like a slam dunk?" the economists said. By taking such an action, the government would allow struggling homeowners to benefit, while the household sector of the economy would be significantly stimulated.

Of course the economists recognized the losers would be agency MBS investors as prepayment speeds would jump dramatically, spreads would ramp out, and supply would surge.

"Admittedly, this could temper the magnitude of our estimated benefit to borrowers - unless the Fed were to step in and serve as the backstop buyer once again," Morgan Stanley economists added.

This last statement dramatically highlights the hurdles and risks that would be faced by attempting to provide an opportunity for credit-impaired borrowers to refinance.

Hasn't the Federal Open Market Committee been discussing the selling of its MBS assets at some point down the road, and returning its portfolio back to a "Treasury-securities-only portfolio"?

Additionally, borrowing costs would be raised dramatically for future homeowners who would have to pay a premium for the risk of potential government refinancing programs. Who would trust investing in an MBS again?, they asked.

Other firms also gave their two cents. Credit Suisse analysts said: "Forget a 'slam dunk', a government-induced refi spike is not even a 'lay up'."

Additionally, analysts said that the government would face "a Herculean task to create large-scale refis." Aside from the eligibility criteria, analysts pointed out that the agencies would have to pay back lenders against put backs and refinancing costs would have to be rolled into the loan for borrowers who are cash constrained. The latter could result in an increased guarantee fee for higher LTV loan.

When it comes to investors, JPMorgan Securities analysts in a report earlier this month estimated the agency MBS market could see $50 billion to $125 billion in losses assuming a 1.25- to three-point re-pricing, with banks and GSEs receiving over 50% of the hit.

These losses would make it difficult for these institutions to lend in other parts of the economy, JPMorgan analysts pointed out.

In the event the government did create a program to spur refinancings, Credit Suisse calculated it would create over $750 billion in supply in lower coupons; the duration impact could be over $200 billion 10-year equivalents.

As servicers are capacity-constrained, Credit Suisse analysts said it could take six to nine months to work through the volume. In addition, they estimated annual homeowner savings at just $10 billion to $15 billion (versus the over $40 billion estimate by Morgan Stanley economists).

Considering what would need to be accomplished to get a program like this done, "We conclude that it is a mountain too high for now," Credit Suisse analysts said.


Other Options

In its report on this possibility of a government-induced refinancing wave, JPMorgan analysts also outlined other potential government policies to stimulate the housing market, but none of which are as extensive.

"Ironically, the worse the economy gets, the more likely there will be a 'heroic' attempt to get refis going," analysts wrote. "At this point, with housing having bottomed locally, we believe the probability of an extreme policy move is low. However, with mortgage dollar prices pushing the $110 level, we must face the possibility - no matter how remote - that a 2003 style refi wave materializes."

Analysts enumerated a number of refinancing catalysts that include a national mortgage rate. This scenario, according to analysts, would allow all homeowners to refinance into a single rate - e.g., 4% - provided by the government regardless of the individual borrower's credit, LTV, etc.

There could also be an 'amnesty' program. This approach would take out the putback risk from the market and would allow, according to analysts, originators to widen the credit box somewhat and let more potential homeowners through the borrowing window for a finite time period. "We could envision a statement in which the GSEs promise not to put back loans that are 'reasonably' within their credit guidelines, and which are made in 'good faith'," analysts wrote.

They also suggested the possible elimination of loan level pricing adjustments (LLPAs), which they cited as another source of friction in the mortgage application process. However, while the pricing matrix theoretically charges as much as four points upfront for the lowest FICO / highest LTV borrowers, realistically the fees are capped at two points, analysts said. Thus, this is clearly not why speeds have been limited to 30 CPR for higher coupons. Furthermore, the Federal Housing Administration still charges upfront and annual insurance premiums, and the removal of LLPAs is inconsistent with this.

There is also the possibility of reclassifying refinancings as modifications. This approach would remove many of the barriers listed above. No further underwriting and added costs or LLPAs would need to be introduced. However, lenders might still need some incentive to do this, such as a government-sponsored fee for each modification performed, which might be politically unpalatable, analysts said, Loan modifications, furthermore, would require that the loans be taken out of the pools.

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