Last week's slight decline in the Mortgage Banker's Association's (MBA) Refinancing Index was considered by Street analysts to be somewhat of a surprise or even an aberration, especially given that the prior week's strong mortgage market rally brought mortgage rates to record lows once again.

For the week ending Nov. 8, the Index declined by just 1% to 4825.6 from 4875.1 the previous week. Researchers from Salomon Smith Barney said that the most reasonable explanation for the modest dip was that the market rally happened on a Thursday, and it actually took some time for the low rates to filter through into the primary market.

"It is likely that the borrowers did not have sufficient time to take advantage of the record low rates," wrote Mikhail Teytel, an MBS analyst at Salomon. "The MBA Refinancing Index decline could have been much more dramatic if not for the rally. Also, Veteran's Day could have contributed to the lower than expected value of the index."

The burnout theory

Analysts from Lehman Brothers noted last Wednesday that over the past two weeks, the Refinancing Index had averaged about 4850, which is in response to a 5.27% par-coupon yield. To illustrate how tepid the response is, researchers said that the last time that rates were at this level, in late September, the Index was up in the mid 6000s.

Lehman researchers stated that the drop in the Index is partly due to a decline in the premium universe. They estimate that at current prepayment rates, about 5% to 6% of the mortgage universe prepays into current coupon - this could explain a 10% to 12% drop in application volume over a two-month period, i.e. down to 5800.

"The current application activity is about 20% below that level and suggests substantial burnout," analysts wrote. They noted that the current application activity would affect prepayments in January.

Other analysts said that when borrowers first see a new low in mortgage rates, a large number of them seek to lock those rates in. Burnout occurs when rates drift higher as they had prior to the recent market rally, and then come back down again to former levels. The borrowers' response is not as intense because those most keen to refinance already had a shot at those rates.

Added to this, high premiums (7.5s and 8s) have been refinaceable for a long time and people in these pools have already had many opportunities to refinance. Aside from this, analysts said that some of these borrowers have had problems refinancing their mortgages due to factors such as small balances and credit problems.

Some experts say, however, that there are still a lot of borrowers out there who are eager to jump on the refinancing bandwagon. In fact, different analysts have said that there is now a significant amount of rate-lock activity, so borrowers are really responding to low mortgage rates. "I would not read too much into the MBA Index-we view it as an outlier" said an MBS observer last Wednesday. "Activity is smoking."

This analyst said that there might have been borrowers who got shut out when rates popped up recently, and who still have an incentive to refinance. Another group might have taken out applications without locking in rates or closing applications. "There has been a tremendous increase in locks over the last few days and this has been reflected in heavy originator selling," he added.

Gauging November speeds

The next question would be: What effect would the market rally have on November speeds? Salomon's Teytel wrote that even though November

prepayments will be primarily based on

loan applications filed in September and October, the recent market rally may have some impact on November speeds due to pipeline fallout - which, in turn, would have an impact on the MBA Refinancing Index levels.

A fallout occurs, he explained, when borrowers do not close already filed loan applications due to lower rates being offered elsewhere. Pipeline fallout is most common during times of sharp mortgage rate declines.

"It is important to mortgage investors because fallout leads to a double counting of mortgage applications, and therefore to overstatements of the MBA indexes," said Teytel. "However in CPR terms, the effect is likely to be small, and given the uncertainty regarding the upcoming prepayments, we leave our projection for aggregate November speeds unchanged at 40% CPR."

He added that the decline in mortgage rates would eventually lead to a considerable rise in prepayments speeds after November. He estimated that speeds of cuspy coupons may go up by 6% to 7% CPR for a 10 basis points decline in rates.

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