With a recent 4.32% print for the Freddie Mac survey rate, primary mortgage rates have hit all-time lows. However, mortgage rates remain stubbornly high compared to rates in the capital markets. The spread between the survey rate and the Fannie Mae current coupon rate has widened to around 100 basis points, well above its five-year average of +58. While this measure is an imperfect proxy for the relationship between consumer rates and market yields, it nonetheless implies that mortgage rates remain "sticky." This relationship is dictated in large part by industry economics, driven by the level of lending activity relative to the mortgage industry's capacity.

As represented by staffing levels, lenders' processing capacity is currently quite low. Data from the Bureau of Labor Statistics indicate that 274,000 workers were employed by the mortgage industry as of last July, less than half of its peak level of 504,000 reported in early 2006. Moreover, these numbers must be taken in the context of the profound changes in the industry. While the decline in employment is in part attributable to a sharp (60%) drop in the number of loan brokers, employment in "real estate credit" has also dropped by roughly half. This suggests fewer employees for key back-office functions such as loan underwriting and closing. While some of the decline in employment represents the demise of thousands of jobs in subprime lending, mortgage industry employment has also been boosted by hiring for areas such as loan servicing and repossessed property management and liquidation. It's difficult to avoid concluding that diminishing resources are being dedicated to the core tasks of processing loan applications and closing transactions.

The data also show that industry employment levels have historically tracked purchase activity more closely than overall application volumes. This reflects the reality that refis come in short-lived and unpredictable waves, while purchase activity reflects longer-term trends. As a result, lenders plan their staffing levels based primarily on their expectations for purchase activity, using available resources to handle spikes in refi volumes. This in turn implies that lenders don't compete on price during refi spikes, since they struggle to handle the incremental volumes.

As a result, primary/secondary rate spreads have historically widened during bursts of refinancing activity. For example, the spread widened markedly during the 2003 refi wave (when overburdened lenders effectively turned away business), and also moved out during the short-lived uptick in refi applications in late 2008/early 2009. The phenomenon was evident again during last summer's decline in rates; the primary/secondary spread has widened almost in lockstep with the recent rise in the Mortgage Bankers Association's Refi Index.

The insensitivity of consumer mortgage rates to declining bond yields directly impacts the housing market. If the spread were closer to its average level, the survey rate would currently be 35-40 basis points lower, giving a boost to home affordability. For example, a 35 basis point reduction in rate would reduce the monthly payment on a National Association of Realtors' median-priced home by roughly 5%, all things equal. The cost to consumers will become even more pronounced if primary rates lag a further decline in market yields, limiting the benefits flowing through to homebuyers from declining interest rates.

Unfortunately, I don't expect mortgage rates to tighten vis-a-vis market rates anytime soon. In fact, it's possible that they will widen further, reflecting the renewed weakness in purchase activity since the expiration of homebuyer tax credits last spring. Further reductions in capacity, whether resulting from headcount reductions or a deployment of resources away from loan processing, would serve to put a floor under consumer mortgage rates even if capital market rates continued to decline.


Bill Berliner is a mortgage and capital markets consultant based in Southern California. His Web site is www.berlinerconsulting.net.

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