Responding to slack demand for new mortgage securities, lenders will soon be rolling out home loans with prepayment penalties to reduce the volatility that has been scaring away investors.

The loans will offer a reduced interest rate in exchange for the penalty. If consumers are receptive, such loans could quickly become mainstream products.

A committee of the Mortgage Bankers Association of America, meeting here last week, approved a plan to develop the new mortgage offering on behalf of its members.

The MBA said it believes penalties would sufficiently deter refinancings - which are driven by interest rate declines - to make mortgage securities more attractive.

The association's move is the first attempt to develop loans with a penalty attached that would be widely available. Mortgage banks originate more than half of all home loans, selling them in the secondary market.

Acceptance of the loans by the secondary market agencies Fannie Mae, formally the Federal National Mortgage Association, and Freddie Mac would be crucial to their success. Some lenders believe the agencies will be more inclined to accept the new product than they were earlier versions because it is expected to offer borrowers a rate break in exchange for the penalty.

How well the product will be received by potential borrowers, however, remains uncertain.

A consumer advocacy group blasted the proposal, even with the rate break. "It's horrible," said Janice Shields, consumer project coordinator at the Center for the Study of Responsive Law, a Ralph Nader group in Washington.

"We should be encouraging people to pay off debt, not punishing them," she said.

Bank of America, lead subsidiary of San Francisco-based BankAmerica Corp., began to offer fixed-rate loans with prepayment penalties and a rate break late last year. The Home Savings of America unit of Irwindale, Calif.-based H.F. Ahmanson & Co. and other big thrifts had introduced adjustable-rate loans with prepayment penalties about a year earlier. But these initiatives have not caught on.

Furthermore, banks and thrifts hold the loans in their own portfolios, while the MBA plan is aimed at developing an active secondary market.

The decision to develop a standardized prepayment mortgage product was not easy for a number of lenders, including Larry Kershner, president of Leader Federal Bank for Savings, Memphis, and vice chairman of the MBA's secondary and capital markets committee.

Although he voted for the proposal, Mr. Kershner said, "I'm sort of torn. I think there would be advantages, but I don't know if Wall Street is going to pay up enough for the protection" the product would offer.

The MBA hopes the product will give a kick start to the sluggish market on Wall Street for mortgage securities. The association reasons that investors would be more apt to buy securities backed by mortgages with prepayment penalties because these investments would in effect carry call protection.

Virtually nothing now deters borrowers from paying off their mortgages when rates drop, a situation that troubles investors in mortgage securities.

The MBA committee presented its proposal as part of a 22-page white paper developed in recent months.

"Perhaps a great deal could be gained if the mortgage industry pursues the development of an alternative mortgage product with prepayment limitations that could be securitized in the secondary market," the white paper states.

Lenders are already saying they would like to see the final product be as customer-friendly as possible. To this end, they want the word "penalty" replaced with a word like "covenant."

The MBA acted after hearing pros and cons from executives who have watched the mortgage industry for decades.

Joseph Hu, senior vice president in charge of mortgage research at Oppenheimer & Co., New York, said he doesn't believe a prepayment penalty would cure the market's ills.

"I don't think the prepayment penalty will expedite the comeback" of mortgage securities, he said.

Mr. Hu said other factors, such as interest rate movements and the way securities are structured, have a much greater bearing on Wall Street demand for mortgage securities.

A different view was offered by Don McCabe, a senior vice president at Dean Witter Reynolds, New York. "Prepayment penalty mortgages are going to be one of the waves of the future," he said. "You may be able to improve the spreads with the prepayment option, and that would make it more attractive to investors."

Leon T. Kendall, professor of finance at the J.L. Kellogg graduate school of management at Northwestern University, insisted the prepayment product is needed to keep the doorway to Wall Street open.

"This really lies at the heart of our business," Mr. Kendall said. "The mortgage-backed securities market is our link to the national and global markets."

Right now, mortgage bankers cannot simply include prepayment products in the pools of mortgages they regularly ship to Freddie Mac, the Federal Home Loan Mortgage Corp.

The prepayment-penalty mortgages are handled solely on a negotiated basis, meaning their prices are worked out individually, a Freddie Mac spokeswoman said.

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