In its statement following the Dec.16 meeting, the Federal Open Market Committee announced that it will "employ all available tools" to revive the economy. These tools include the large-scale purchase of agency MBS and debentures, as well as the possibility of buying long-term Treasury securities. A key goal is to provide support to the mortgage sector and the housing market, while stimulating a refinancing wave to both improve the cash flow situation of borrowers and support the earnings of mortgage lenders.

The 75-plus basis point decline in conforming fixed mortgage rates since mid-November has triggered a pop in refinancing application activity, judging by the Mortgage Bankers Association's refinance index, as well as the December prepayment report. Nonetheless, primary conforming mortgage rates remain stubbornly high relative to Treasury yields; the spread between the Freddie Mac survey rate and 10-year Treasury yield is almost 100 basis points higher than its five-year average (2003 to 2007). Along with factors dictated by the current economic and lending environment, this suggests that a 2003-style refinancing wave is unlikely.

Mortgage rates have been propped up by a number of factors. Agency passthrough spreads remain quite wide by historical standards, even after the Fed began purchasing pools at the beginning of the year. In addition, the dearth of lender processing capacity has contributed to the stickiness of primary rates. According to the Bureau of Labor Statistics, total employment in "Real Estate Credit" has shrunk by almost a third since the fall of 2006, and many remaining staffers have been redeployed from production to areas such as loan modification analysis and processing. Since lenders have all the applications they can handle, they don't have a strong incentive to compete aggressively for business by trimming rates, a phenomenon also characteristic of the 2003 refinancing wave. Staffing shortages will also tend to increase the lag between application and funding; in the current climate, lenders are unlikely to aggressively add staff, but will rather let the lending queues build.

Other considerations also cloud the refinancing picture. Many homeowners will have difficulty refinancing their loans (and closing on applications) in a regime where strong credit, full documentation, and a low LTV are virtually mandatory. This is especially true with respect to LTV; the combination of equity takeout and the nationwide drop in home prices has left many potential borrowers with minimal (or negative) equity.

The breakdown in the securitization markets also means that the Fed's actions won't translate directly into lower jumbo mortgage rates. Pricing in the private-label CMO market remains turgid, even for deals backed by high-quality loans. The breakdown in securities markets has thus severed the link between capital market yields and nonconforming mortgage rates, forcing loan pricing to be determined by lenders' subjective ROE targets and loss assumptions. Short of buying the product outright, this suggests that there is not much the Fed can do to push down jumbo rates.

Taken together, these factors suggest that the absolute level of prepayment speeds will experience a steady and protracted increase, rather than an immediate spike. Speeds should peak well below those seen in 2003, the last time conforming rates breached their long-term lows. This implies that many would-be borrowers will have trouble closing on their applications, making the refinance index a less reliable indicator of future prepayment speeds.

A related and important question is whether prepayment models are projecting speeds that are too fast in the current environment. If prepayment speeds don't spike as much as forecast, investors will be forced to adjust their portfolios to account for longer MBS durations. The resulting duration shedding will put upward pressure on long-term interest rates.

Bill Berliner is a financial consultant based in Southern California. His Web site is

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

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