As the year got underway, expectations were for refinancing activity to surge as the Federal Reserve began its program to buy $750 billion worth of MBS with the aim to force mortgage rates lower.

The Fed eventually increased the amount it would buy to a total of $1.25 trillion and added $300 billion Treasurys into the mix. The government also started its Making Home Affordable Plan in March to help borrowers who were underwater to be able to refinance their mortgages.

As a result, the market expected to see the largest refinance wave this summer since the summer of 2003. Predictions were for prepayment speeds to peak in the 55-65 CPR area for 2006-2007 vintage 5%s through 6.5%s from between 5% and 11% CPR levels in December.

Refis Surge Initially

Refinancing activity started to respond beginning in late December when the Fed announced its MBS buy program. The Mortgage Bankers Association's (MBA) Refinance Index surged to 7414 by the week ending Jan. 9 from below 2000 in October and November, and 30-year fixed mortgage rates declined to an average of 5.01% from over 6% in mid-October through November.

After that, activity eased off into March, ranging in the 3000 to 4000 area before picking back up following the Federal Open Market Committee's (FOMC) mid-March meeting where the committee announced additional MBS purchases in 2009 along with $300 billion in longer Treasurys. Another burst in refinancing activity pushed the Refinance Index to over 6800 in early April with mortgage rates at a record low of below 4.80%. As of the week ending May 29, however, the Refinance Index was down to 2954 as mortgage rates rose well above 5% and Treasury yields rose on supply concerns, and was further exacerbated by convexity-related selling. After closing in on 2% in mid-December, the 10-year Treasury yield was in the 3.70% area by early June.

Wave Turning into a Ripple

Following an initial surge in speeds of nearly 100% in January from December, overall FNMA speeds have increased just 30% to an average of 21.4 CPR in April from 16.4 CPR in January, according to eMBS. Breaking it out further, 2006-2007 vintage 5%s through 6.5%s have prepaid between 30 CPR and 17 CPR, with the lower coupon 5s and 5.5s prepaying faster than 6s and 6.5s.

Recently, JPMorgan Securities analysts said they now expect speeds on 2006-2008 vintage 5.5s and 6s to stay below 40 CPR, while 5s may top out in the low 30s and 6.5s may not even hit 30 CPR unless buyouts pick up.

"These levels are roughly 10 CPR below what we thought the market should be capable of producing," they said. At this time, the consensus projection for July prepayment speeds ranges between 38 CPR and 27 CPR for 06-07 vintage 5s through 6.5s.

Contributing Factors to Muted Response

There is a wide range of influences lending to the limited response in refinancing activity, and in turn keeping prepayment speeds - especially in higher coupons - relatively muted. Capacity constraints at mortgage lenders have been considered the primary factors contributing to the muted response in refinancing activity relative to the historic low level in mortgage rates. This ranges from lack of adequate staffing to meet the demand to the need for new systems to handle the new programs.

Along these same lines is limited competition, which has kept the primary-secondary spread difference relatively wide. Just three issuers currently dominate the market: Wells Fargo, Bank of America (BofA) and Chase - all keen on protecting NIMs and capital levels. These firms make up over 50% of the origination, FTN Financial analysts said in a report. Back in August of 2003, the top three originators (Wells Fargo, Countrywide and Washington Mutual) comprised just 33% of the overall issuance, they said in a report in May.

Borrowers also appear to be very sensitive to mortgage rate levels, says BoA/Merrill Lynch, with activity typically declining as reported rates move closer to 5% and the "no-point rate" adds several basis points on top of that rate. Another limiting factor is that many borrowers cannot roll all of the closing costs into the loan due to LTV and GSE constraints. This hindrance forces borrowers to come up with the cash.

Additionally, according to GSE servicer guidelines, lenders are not allowed to specifically solicit Fannie Mae or Freddie Mac borrowers to offer the option of refinancing. This means servicers have to wait for the borrowers to come to them, analysts said. Furthermore, Freddie Mac will allow borrowers to refinance only through their current servicer, which is a limiting factor in terms of refinancing activity.

Underwriting standards also remain tight. The Senior Loan Officer Opinion Survey for April reported 48.1% of large bank respondents' credit standards for prime residential mortgage loans remained basically unchanged for the past three months, while 44.4% said standards had "tightened somewhat" and 7.4% reported "tightened considerably." No banks eased. In line with this, a study conducted by FICO reported that from October 2007 to October 2008, 30.5% of consumers dropped below a 680 credit score. This makes it more difficult for these borrowers to refinance, partly because of the increased interest rates associated with lower credit scores and the tight lending standards among banks.

While the GSEs' refinancing programs allow those with LTVs of up to 105% to refinance, ongoing declines in home prices, as well as job losses, are prohibiting certain borrowers from being able to refinance. The latest FOMC minutes made mention that housing seems to be nearing a bottom, but based on these projections it appears housing and home prices could bounce along the bottom for a while.

In Freddie Mac's latest forecast, they project the Conventional Mortgage HPI to decline 4.3% this year and 1.5% in 2010, while the Standard & Poor's/Case-Shiller Index is projected to fall 12.8% in 2009 and 3.0% next year. According to the latest S&P/Case-Shiller National Home Price Index, home prices dropped 19.1% in the 1Q09 compared with a year ago - the largest decline in the series' 21-year history. Prices across the U.S. are back to similar levels as 4Q02, according to the report.

Lower mortgage rates are seen as the primary stimulus factor. Mortgage rates are influenced by a number of inputs, and any one or all are seen as helping borrowers to be able to refinance. The Fed increasing their buying of Treasurys would likely bring overall yields back down and, in turn, mortgage rates. JPMorgan Securities analysts also suggested the removal of all LLPA g-fees by Fannie Mae, while Freddie Mac needs to open up its streamlined refinancing channel to all originators as keys to making mortgage rates more attractive.

Increased competition would also narrow the primary-secondary spread and induce refinancing activity, Deutsche Bank Securities analysts said, and could be done through a Fed/Treasury Department facility or via the government agencies. The MBA has been working on trying to revive warehouse lending.

At this time, however, the status quo is being maintained as the Fed gauges whether or not it needs to do more. "Lack of policy response to low refinances and the significant selloff and burnout dynamics indicate that a refi wave may no longer be a threat," Deutsche analysts said.

(c) 2009 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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