With mortgage rates entering new ground, and firms struggling to capture prepay speeds, determining the effective mortgage rate is becoming a key focus for researchers. Different firms, however, have different notions of what the effective mortgage rate is.

Some prepayment analysts think that using primary rates, which are based on the Freddie Mac Primary Mortgage Survey, would be the best route. Others prefer using secondary mortgage rates in their prepayment modeling.

According to some researchers, there is a good argument against the Freddie Mac weekly survey because it does not come out on a daily basis. Most prepayment analysts would like to have an estimate that they could update everyday and, in this case, they would rather use secondary market rates. In fact, pretty much all OAS models use secondary mortgage rates because they cannot generate 30-year projections for the Freddie Mac rate.

Andrew Davidson, president of the Andrew Davidson and Co., Inc., said that his model is based on the secondary rates because over time, this is the rate that would drive prepayment speeds; the primary market will follow the secondary market rate. "It is very difficult to do consistent forecasting off the primary market rate," said Davidson. "Though there is a good argument for using primary market rates, the problem is we do not view it as a very consistent source historically or in forecasting through an OAS model."

Lehman model

In a Lehman Brothers report released last week, researchers said that they only use secondary mortgage rates in their production prepayment model.

They noted that secondary rates could serve as a good proxy for the effective primary rates available to borrowers. This is considering that the fixed-rate market is very competitive and since most originators securitize the mortgages they originate, the economics of origination would depend mainly on secondary market execution - meaning the primary rate offered minus par-coupon yield must cover guarantee fees, origination costs and a reasonable profit for the lender. Lehman said that if a lender veers away from this rate, it might mean sub-par returns on mortgage origination.

One factor that may go against the above arguments is the divergence in primary market rates given that effective primary rates are considered "stickier" than secondary rates, and that the option cost may be overstated because of the reliance on secondary rates. However, analysts from Lehman stated that survey data may be unreliable considering that surveys show posted rates rather than the actual rates borrowers get. Further, because surveys are not weighted according to origination volume, even lenders whose posted rates cannot be considered competitive will have an impact on survey results. This causes average survey data to overstate the effective rate that borrowers get.

Another crucial question is whether the use of secondary mortgage rates would remain reliable when the mortgage banking industry is capacity-constrained. Many other analysts believe that the banking industry tends to raise primary rates versus secondary rates to limit demand. However, Lehman believes that mortgage originators have more options than to turn away customers, including extending the closing period from the usual 45 days to 60 days which would increase originator capacity by 33%.

Researchers analyzed the impact of these longer rate locks. "Based on our analysis, we came to the conclusions that though the difference between primary rates and secondary rates may widen out a little at times of high capacity utilization, it should widen no more the order of six to eight basis points," said Amitabh Arora, a senior vice president at Lehman. "People who pay a lot of attention to the Freddie Mac survey data maybe missing the true movement in interest rates."

In defense of primary

mortgage rates

Some prepayment analysts believe that in analyzing prepayments, researchers should really be looking at the primary mortgage rate. Though the secondary mortgage rate is relevant to how bonds trade, homeowners generally do not know or care what this rate is. So from a fundamental point of view, experts say the primary mortgage rate has to be what governs prepayments directly because this is what the homeowner sees.

"From a prepayment modeling perspective, you really want to use the rate that the consumer is seeing," said Dale Westhoff, senior managing director at Bear Stearns. "So we focus on the primary rate or the rate that the consumer is seeing and adjust the theoretical mortgage rate to be consistent with that consumer rate."

Westhoff said that this is generally not a problem but when lenders are reaching their capacity limits and they are not reducing their margins as quickly as they might otherwise, the consumer rate or the primary rate usually gaps out versus the secondary rate. The differential between these rates has been as wide as 20 basis points to 25 basis points. Currently, it is running at about 15 basis points, which is wider than normal but not at its peak level.

The problem is if prepayment models use a theoretical rate based on a synthetic par priced MBS, there is a possibility that they will over predict speeds when lenders reach capacity. Ironically, this has helped some models keep pace with actual prepayment speeds that have come in well above expectations. Nevertheless, in general, this problem tends to reduce model accuracy.

"Our models are so sensitive to the mortgage rate assumption that even one basis point of error can affect our short-term estimates by almost 1 CPR," said Westhoff. "This is why we pay very close attention to where that consumer rate is."

In terms of the survey rates published, other analysts said that these rates are generally consistent with the rates that mortgage bankers offer. They noted that the inaccuracies in survey rates are not nearly as great as the inaccuracy in trying to gauge the spread between primary and secondary rates.

Capacity issues

There is also the question of the reliability of primary mortgage rates during the times when originators run at peak capacity. An MBS analyst said, "It is a fact that in times of high capacity, rates do get sticky and originators do turn away customers."

He also stated that it is not that easy for mortgage originators to ramp up operations when there is a deluge of applications.

"It is easy to hire people to take applications," he noted. "Getting people to actually put together the paperwork and to get to closing is the hard part. This is a relatively high- paying job that requires experience and training. So it is not like you can just instantly ramp up capacity. Originators have also been pretty wary of adding people for short term refinancing spikes because when volume falls off, that would mean layoffs."

He added that the spikes in refinancings tend to come in waves. Only a few months ago, the industry was probably running at 100% capacity. Now the industry is back to running at 150% capacity. The analyst said it would be unlikely that originators would make hires to cope with the current refinancing boom, but would probably just make do with what they have.

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