The recent drop in market yields has led to a discussion on the "true" level of consumer mortgages rates, i.e., a realistic and consistent estimate for the level of mortgage rates at the consumer level. This rate is clearly important, whether it's being estimated from secondary market rates or is being measured empirically (i.e., through a survey such as the Freddie Mac Primary Mortgage Market Survey rate). Unfortunately, no single rate exists, even among individual products. As we've noted in the past, rates themselves are not calculated directly. Rather, the all-in execution (which accounts for all costs, including hedging and margins) at each rate point is calculated, and the difference between the all-in execution and par are the points associated with that rate. For example, if the all-in execution for a loan with a 6.375% rate is 99.5, the 6.375% note rate has 1/2 point associated with it. Therefore, at any given time, the "mortgage rate" is really a matrix of points and rates, as demonstrated in Exhibit 1.

Interestingly enough, however, the relationship between rates and points is neither linear nor constant. Negative points (i.e., note rates where a rebate is paid to the borrower) are associated with above-market rates and are used to price "no-cost" loans. Because of the difference in how servicing at different rate levels is valued, the relationship of rates to points is significantly different for rates with negative and positive points. Essentially, lenders become wary about putting up much up-front money in exchange for a higher rate, given the ability of the borrower to prepay the loan and extinguish the servicing strip.

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