Despite the Federal Reserve's effort to push down mortgage rates through MBS purchases, the spread between primary and secondary mortgage rates has remained stubbornly wide, according to Merrill Lynch analysts in a recent report.

While the higher g-fees from the GSEs and increased servicing costs resulting from delinquencies have contributed to the wider spread over the past year, Merrill Lynch analysts said. They also added that most recently, other factors such as cost of hedging the pipeline, points paid by the borrower as well as originator capacity constraints are reasons why the spread has widened even further.

The costs of hedging have increased because of longer rate-lock periods and uncertainty about pull-through rates.

Merrill analysts noted that originators have extended the rate-lock period to 60-90 days from 30-60 days of two to three months ago. Uncertainty regarding pull-through rates has also increased significantly, Merrill analysts said, as originators are unsure as to what percentage of refinance applicants will have enough equity in their homes to qualify for an 80% LTV.

Analysts said this risk means that originators have to hedge a higher percentage of their pipelines using options. They attribute 15 to 20 basis points of the recent spike in the primary to secondary mortgage rate spread to this.

Points paid by the borrower versus the discount on the mortgage rate, or the difference between the no point and one-point conforming loan rate is a factor that Merrill analysts believe the market is not paying enough attention to.

They noted the spread between the two is up to 75 basis points from an historical level of 25 basis points.

"Why are originators charging 75 basis points premium on a no-point mortgage versus a one-point mortgage?" analysts asked. They believe it is a result of the recent sharp decline in MTM valuations of servicing assets, adding that this is supported by valuations of coupon swaps, Trust IOs or buy-up/buy-down multiples offered the GSEs.

Putting all this together, Merrill calculated that from January through November of 2008, the difference between the one-point primary and secondary mortgage rates increased to 55 to 60 basis points from 45 basis points because of the higher g-fees and increased servicing cost.

The increase to 110 to 115 basis points spread seen in December and January they believe is because of hedging costs, depressed valuations of the servicing asset, along with capacity constraints.

One factor which should help reduce this spread is increased originator capacity, which is in process.

Another factor that would help is the no- appraisal refinancings which would reduce the rate lock period, as well as, pull-through rate uncertainty.

In fact, on Wednesday Fannie Mae announced some updates to its Desktop Underwriter (DU) to help streamline the underwriting process for Fannie loans. One change was the waiving of the reappraisal requirement for certain refi borrowers. Barclays Capital, however, said that the change though should just have a marginal impact on borrower refinanceability and prepayments.

Based on current information, it appears to them that the DU will use HPA data to estimate home values for existing Fannie Mae loans. Those that fall within current underwriting guidelines would likely be offered the reappraisal waver. "So, more than anything, this change represents an operational efficiency," they said.

A final factor that would help spread difference between primary and secondary rates, said Merrill, would be improvement in coupon swap valuations.

Still, analysts don't believe the spread is likely to go back to its historical level of 45 to 50 basis points anytime soon due to the higher g-fees and adverse delivery fees charged by the GSEs, along with higher servicing costs related to the current housing environment.

They think the spread will settle down to the 55 to 60 basis point area at low Refinance Index levels and at about 80 to 85 basis points at moderate Refinance Index levels.

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