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Market deals with capacity constraints: are originators increasing lending rates?

With prepayments set to reach all-time highs, the question of whether mortgage bankers will be able to handle the unprecedented volume has been foremost on market players minds.

Some Street analysts seem to be giving the thumbs up.

According to Lehman Brothers, the significant increase in October prepayments showcases the mortgage banking industry's ability to sharply ramp up production.

With the huge deluge in applications, there is anecdotal evidence that mortgage originators who are operating at capacity are jacking up rates to curtail volume.

An MBS analyst said that a couple of originators he had spoken with admitted they were offering higher rates but the widening may be no more that 10 basis points.

"There is definitely a stickiness to rates," said another MBS analyst. "It goes back to the issue of capacity. If you were at capacity why would you drop your price? Mortgage bankers are increasing their margins, and that's a big factor, just because of the competitiveness of the industry. Given the capacity issues, the price competitiveness of the industry is much reduced."

However, some analysts say that consumers are now refinancing at higher rates not necessarily because originators are increasing their margins but because it is taking mortgage applications longer to process.

According to David Montano, director of mortgage research at Credit Suisse First Boston, on the average it currently takes about eight weeks for an application to close. Thus the rates that would be offered for those who apply this month is what mortgages will trade for in December or January, when the refinancing actually occurs, and not what they are going to trade for in November.

"The more forward you are in terms of being able to close your mortgage, the higher the rate you would get," explained Montano.

The actual rate people are currently being offered is not as good as the commitment rate which is also the 30-day rate. Because of the significant number of people applying, it would be hard for applications to close in 30 days, thus barring applicants from enjoying the 30-day rate.

However, the fact that the actual rate consumers are being offered is about 10 basis points higher than the 30-day rate would not deter applications from coming in.

"The next 10 basis points is not going to make any difference when mortgage rates have declined 100 basis points since July," said Montano. "This is not really going to slow people down. But it might have some impact on people right on the cusp."

Capacity in three stages

In a Countrywide Securities report, analysts said it would be useful to think of capacity in terms of three stages, namely: front-end (entails taking and recording the applications); intermediate (involves doing the title search, appraisal and other required elements); and back-end (preparing the loan documents and funding the loan).

"There are capacity issues all along the pipeline," said Bill Berliner, senior mortgage strategist at Countrywide.

With the current high volume of applicants, originators need more people to take and record these applications, thus front-end capacity becomes an issue.

Since the current refi wave began over a year ago, Countrywide wrote that capacity has already been steadily ramped up, and finding qualified candidates is currently difficult. It also remains to be seen whether originators will further increase front-end capacity, since the increase in refi applications may be temporary.

Capacity in the intermediate stage is even more difficult to increase rapidly, according to Berliner. Since some of the processes, including the appraisal and title work, are outsourced, the industry does not directly control resource allocations, and bottlenecks are increasingly commonplace.

There are a number of implications to the capacity issue. Countrywide wrote that the difficulty in processing applications will cause the "tail" of the origination process to lengthen. This means that the duration of the refinancing cycle will be extended, and also suggests that the normal seasonal slowdown in prepayments will not be experienced this year.

Also,the normal "stickiness" of mortgage rates in an environment of falling Treasury yields will be more pronounced, as the constraints on capacity reduce the price competitiveness of the industry.

The report also questioned what will happen in the future when rates rise. "Since originators have added capacity throughout the past year, the industry will arguably be overstaffed once rates move higher and refi activity is dampened," said Countrywide. "It is possible that, at that point, the pressure to utilize capacity will increase the price competitiveness of the industry, pushing mortgage rates lower than they would normally be given capital market rates and prices."

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