The mortgage bond market is not only struggling to get its bearings in the wake of last weeks tragedy but also bracing for a surge in prepayments as interest rates fall.
Trading has been thin. By one estimate, on Monday the market was trading at 5% to 10% of its full capacity of $100 billion a day. And with mortgage rates expected to move lower on reaction to the Federal Reserve cut Monday, concern is shifting to the possibility that the refinance boom could get another burst of life, which could further depress bond prices.
There is likely to be a sizeable increase in refinance activity, said Arthur Q. Frank, the head of mortgage research at Nomura Securities International. I think we will see prepayment speeds as fast as we did in October of 1998, and it could get worse if mortgage rates keep coming down.
Last week Freddie Mac reported that 30-year mortgage rates fell to an average 6.86%, their lowest since Feb. 19, 1999, when they averaged 6.82%. Rates could fall even further this week, according to Freddie Macs chief economist, Robert Van Order.
Though this is good news for originators, it is negative for the mortgage-backed securities markets. Falling mortgage rates boost origination business, because borrowers refinance their loans for better rates. But investors in mortgage-backed securities suffer, because some of the collateral underlying their bonds gets paid off early, denying them interest payments.
On Monday the Fed cut short-term interest rates by 50 basis points, and some observers expect another reduction when the Federal Open Markets Committee meets in mid-October.
Joseph Morgan, a fixed-income analyst with Seneca Capital Management in San Francisco, said lower rates are expected to prompt refinancings, but not immediately. People are more attuned to watching Peter Jennings on TV than watching their own finances at the moment, he said.
Still, he and other analysts noted that much of the mortgage bond market is concentrated in loans carrying 6.5% and 7% coupons, loans that originated during the last refinance boom, in 1998. Now that mortgage rates have dropped below 7%, the markets have already breached areas where people in the 7% pools do have the incentive to refinance, and were getting close to the people in the 6.5% pools who could refinance, Mr. Morgan said. Thats a lot of money out there.
Mr. Frank said 75% of Fannie Mae pass-through mortgage bonds, a major part of the market, would be affected if people with 6.5% to 9% coupons refinanced.
Other sources estimated that 60% of the mortgage market is eligible to refinance. One source, who asked not to be identified, predicted that low interest rates will cause the most intense and prolonged refi boom ever seen in history.
The economic uncertainty that we face will heighten the threat of a historically strong and long refinancing boom, this source said.
While the Mortgage Bankers Associations index of refinance applications dropped 2.9% for the week ended Sept. 7, volume is still quite high this year. The MBAs composite index, which includes both refinancing and purchase applications, dropped about the same amount for the week but was up 76.7% compared to a year ago.