We expect the mortgage market's health to improve from good to robust this year, because we see rates, especially on the short end, continuing to decline. Hence, 1996 should be a very solid year for mortgage lenders.

Even so, a repeat of last year's stunning rise in stock prices won't take place. This year, we expect the shares of selected mortgage lenders to rise 10% to 20%. Some shares, particularly those of mortgage bankers and Fannie Mae and Freddie Mac, may well exceed those estimates if there is a refinancing boom.

It is our view that a refinancing boom is aborning. The only question is how big it will be.

Currently, refinancings account for an estimated 40% to 45% of originations, while the remaining 55% to 60% are mortgages for home purchases.

The recent rise in refinancings has been fueled by bond yields that are approaching two-year lows, leading to a fall in mortgage rates of more than 200 basis points during 1995, from 9.3% to 7.1%

This has made refinancing an attractive option for three types of borrowers. First, there are those who have took out adjustables, after the 1993 boom, and have recently experienced rate increases. Second are those who refinanced in 1993 and are now looking for a lower rate. Third, those who missed the 1993 boom may refinance this time around.

Overall, we expect mortgage originations (both refinancings and purchase loans) to reach $790 billion to $800 billion this year, up from an estimated $680 billion in 1995. The record is $1.1 trillion in 1993.

The current environment - facilitating originations of low-rate fixed loans - benefits those engaged in mortgage banking, defined as those who make such loans and sell them into the secondary market, mainly to Fannie Mae and Freddie Mac. These two housing-related government-sponsored enterprises are also benefiting mightily from the current environment.

So, mortgage banking no longer includes just mortgage bankers such as Countrywide Credit and North American Mortgage. It also includes portfolio lenders, which are now being forced to make fixed-rate mortgages and sell them off in order to compete effectively.

Unlike during the refinancing boom of 1993, when portfolio lenders - S&Ls and commercial banks - largely sat on the sidelines, this time around they are fighting the pure mortgage bankers head on for market share. These portfolio lenders would much prefer to make adjustments and retain them - after all, this is their basic business.

Moreover, retained loans act much like annuities that give off income streams over the long term. Sales into the secondary market are positive for earnings, but are one-time events.

However, if the Federal Reserve cuts short rates in 1996, adjustables - priced off the short end of the curve - could become very price competitive again, especially if very low teaser rates come back into vogue. If that happens, the shares of S&Ls and banks could surprise on the upside in 1996.

What could darken our bright outlook for mortgage-related shares in 1996 is, of course, a rise in rates. But a rate increase is always a threat to the mortgage market, and is not specific to a particular year.

A second cloud, and we believe it holds more real risk to our outlook, is concern about credit. In the 1995 third quarter, single-family delinquencies rose a modest 9 basis points to 4.24%. But this was the second straight quarterly increase and prompted widespread predictions that delinquencies will rise at least through 1996.

We agree that they will, but think the problems will not impact earnings or share price projections - beyond our expectations - for mortgage lenders. The recent upticks, not unexpected, were caused by three factors: normal seasoning, mortgages with high loan-to-value ratios, and upward adjustment in prices.

Future jumps in delinquencies should be moderated by the refinancing boom, which we see forming, and by firming house prices. Now that the fallout from 1980s-style speculation has pretty much run its course, house prices are again appreciating slowly, providing a buffer against losses.

In short, 1996 should be a solid but not spectacular year for the stock of mortgage lenders.

Mr. O'Donnell is an equities analyst with Prudential Securities, New York.

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