Mortgage prices across most of the stack are sitting at record highs, while mortgage rates are near record lows.

Historically, a situation like this would lead to lower coupons being pressured by supply and higher coupons by prepayment risk. At this time, neither is considered as a significant risk and are expected to stay this way for awhile.

According to Freddie Mac's weekly survey, 30-year mortgage rates are in the low to mid-4.70s with an average 0.7 point, which places the no-point rate in the low 4.90s.

As of the week ending June 18, the Mortgage Bankers Association's (MBA) Refinance Index was only in the 3200 area. In April 2009, when mortgage rates initially reached similar levels as the Federal Reserve ramped up its MBS purchases and the government started promoting programs to help borrowers, the Refinance Index reached over 6800.

"Despite the historically low rates, many homeowners have already refinanced recently, remain underwater on their mortgages, have uncertain job situations, or have damaged credit following this downturn, and therefore may not qualify to refinance," said Michael Fratantoni, MBA's vice president of research and economics.

 

Tight Credit and Weak Housing Outlook

Underwriting standards remain extremely tight as noted in the last Fed Beige Book and in the Federal Open Market Committee's (FOMC) latest statement.

Regarding the housing market, the statement said that bank lending has continued to contract in recent months.

In addition, Barclays Capital analysts said in a report that stricter rules recently announced by the GSEs that will take effect in coming months further tighten the credit box, while lenders are increasingly cautious when underwriting as the GSEs have become much more aggressive in put-backs.

Home prices, while recently posting some year-over-year and month-over-month increases, are at risk of losing some ground. Steve Abrahams, head of Deutsche Bank Securities' securitization and MBS research, said that the outlook for homeownership will probably continue to trend downward, "and given the heavy overbuilding, tight underwriting and current high unemployment, U.S. home prices stand to drop by 4.6% to 10.8% by the end of 2011."

According to the latest Federal Housing Finance Agency (FHFA) monthly House Price Index for April, home prices jumped 0.8%, which was much stronger than the 0.3% that was predicted; however, the FHFA attributed the strength in home prices to the homebuyer tax credit.

David Blitzer, chairman of the index committee at Standard & Poor's, also was pessimistic following last month's S&P/Case-Shiller Home Price Indices.

"The housing market may be in better shape than this time last year, but, when you look at recent trends, there are signs of some renewed weakening in home prices," he said.

In another S&P report called Variations In U.S. Shadow Inventories Could Spell Home Price Declines In Some Areas, Stabilization In Others, credit analyst Diane Westerback stated: "We estimate that the entire shadow inventory of distressed properties currently outstanding that back non-agency residential mortgage-backed securities would take nearly three years to clear at the current average national resolution rate. Given this backlog, we believe that average home prices could fall again if demand doesn't rise in step with the potential influx of supply."

Since the expiration of the homebuyer tax credit on April 30, various housing statistics have shown unexpected or larger-than-expected declines, which also do not bode well for home price strengthening and, as a result, refinancing potential.

The National Association of Home Builders(NAHB) Housing Market Index plunged five points to 17 in June. While homebuilders were expecting some pullback on activity following expiration of the tax credit at the end of April, "the reduction in consumer activity may have been more dramatic than some builders had anticipated," said NAHB Chairman Bob Jones.

Housing starts plunged 10% versus a 3.3% decline in May to 593k following expiration of the homebuyer tax credit at the end of April.

Existing home sales in May fell 2.2% to a SAAR of 5.66 million units in May versus an expectation of a 6.6% increase to 6.15 million units, while new home sales plummeted to 300,000 - their lowest sales rate on record - versus an expectation of a 19% drop-off. In addition, the median sales price for new homes fell 1% over the month to $200,900 and is down 9.6% from a year ago. The report had a negative impact on global equity markets as it raised concerns regarding the global economic recovery.

The MBA's Purchase Index has dropped 39% from April 30 through June 18 as a result of the homebuyer tax credit expiration.

The status of the job market also does not look conducive to stimulating housing activity.

The May employment report shocked the market with only a 41,000 increase in private employment. Overall job growth was reported at 431,000 versus a consensus call for over 513,000 jobs created. However, 411,000 were Census-related and thus temporary.

In the FOMC's statement on Wednesday, it noted that household spending remained constrained by high unemployment, while employers remained reluctant to add to payrolls. The lack of jobs is a limiting force on household formation, Deutsche's Abrahams said, and is a needed factor in helping to reduce the supply overhang.

 

Stimulating Refinancing Activity

At this time, Barclays Capital analysts said they do not expect to see a significant pickup in refinancing activity unless the no-point mortgage rate drops below 4.75%, which is more than 20 basis points away.

Given the stickiness of primary/secondary spreads, analysts estimated that the 10-year note would have to drop to below 2.80% to achieve this.

Credit Suisse analysts said rates would have to be under 4.5% to lead to a meaningful pickup in refinancings, but even then activity should be muted compared to historical standards.

On the other hand, JPMorgan Securities analysts said it might require a plunge to 2.50% on the 10-year note to trigger a significant wave. At that point, 2009 4.5s and 5s will experience the biggest response to refinancings due to the better credits of the underlying borrowers.

If mortgage rates do drop to the levels suggested above, net demand is expected to continue to exceed supply in 2010, said Credit Suisse analysts - even in sharp rallies. They predict overall net supply would increase by less than $50 billion even in a 4.25% mortgage rate scenario.

Citigroup Global Markets economists also anticipate that investor demand - especially from banks and overseas buyers - will stay robust, particularly in higher coupons with the curve remaining steep.

With the Fed on hold through 2Q11, Citigroup economists currently project prepayment risks will be muted and there will be limited loan demand.

Prepayment Outlook

The limited ability of many to refinance is keeping prepayment speeds relatively low. At this time, Freddie Mac 2008-2006 vintage 6s through 7s are projected to prepay in the mid-20 to low-30 CPR range in June through August.

Meanwhile, FNMAs are predicted in the low- to mid-30 CPR area. Analysts said the biggest risk to prepayments is if underwriting standards are eased, which is not expected anytime soon.

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