What would a 5.5% mortgage rate mean to the industry?

The question arises because Lawrence Lindsey, a Federal Reserve Board governor, said in a recent speech that the Fed had a long-term target of a 1% inflation rate and that that would mean a 5.5% rate on 30-year fixed mortgages.

Mr. Lindsey said such a scenario could give homebuyers access to the same rates his parents had.

That sounds great, but it's really a good-news, bad-news scenario for the mortgage business.

On the plus side, it could mean a wave of refinancings that would dwarf the 1993 boom. In fact, all the loans refinanced in 1993 would be eligible for new refinancings. It could also push home purchases up dramatically. A likely result: originations topping the record $1 trillion mark.

On the minus side, prepayments would surge, and mortgage bankers lacking the ability to replace prepaid loans quickly with new originations would be clobbered by the drain on their portfolios of servicing rights. Under new accounting rules, that would lead to significant writedowns of servicing value.

For investors, it's also good news and bad news. Mortgage securities would be strengthened by declining rates but weakened by loan runoff. On balance, investors would likely take a beating.

And how likely is it that the Fed will succeed? While few observers are optimistic for the near future, nobody dismisses the possibility over the longer term.

"That level of inflation is certainly a possibility if the economy goes into recession," said Henry Kaufman, the interest rate guru who heads his own firm. "For the next year or so, the economy will continue to expand, and this will probably require a tighter monetary policy. A year from now, rates will be a little higher than they are now."

David Berson, chief economist at the Federal National Mortgage Association, was a bit more optimistic. "I think it's doable, but it's a stretch," he said. "It's difficult to get rates down to what our parents got, with similar inflation, if we don't get the federal budget down."

He said that, in real terms, a 1% inflation rate may not be so far away. Economists believe the consumer price index overstates inflation by one to 1.5 points, he said. Thus, the real rate of inflation has been 1.5% to 2% in recent years.

But financial markets must reduce the inflation premium built into current rates if they are to fall significantly, he added.

The prospect of a big drop in mortgage rates certainly underscores the need for hedging or other defensive measures.

Strategies such as that of North American Mortgage Co., which sells most of its servicing soon after the loans are originated, could spread. Fannie Mae and Freddie Mac are planning to begin securitizing loans with servicing rights attached, and that would be a move in the same direction.

Another byproduct of a 5.5% mortgage rate would likely be a big increase in the market share of the federal housing finance agencies and of mortgage banking companies. Their share surged in the last refinancing boom and would likely climb again. The losers would be portfolio lenders such as thrifts, many of which have already been abandoning mortgage investment.

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