Given stable mortgage rates at recent levels (6.75% to 7%), we believe that refinance activity will begin to subside by spring and will decline by 50% in 1994 from 1993 levels - and by another 60% between 1994 and 1995.

We estimate that refis would fall from $535 billion this year to $265 billion in 1994 and to $115 billion in 1995, a decline of 80% from peak 1993 levels. We expect total originations to drop from $ 1 trillion this year to $770 billion in 1994 and $640 billion in 1995, a decline of just 35% from this year's peak.

Whenever volume contracts, the risk of price competition intensifies, as mortgage market participants are tempted to cut price to compete for share of a smaller market, in an effort to defend new business volumes.

These pressures will be most acute for mortgage bankers, who derive as much as 65% to 75% of their new loan volume from refis, versus just 55% for all lenders, and for whom production capacity and employee head count have expanded dramatically over the past 36 months of burgeoning refinance activity.

Price War Possible

The possibility of a full-blown price war cannot be ruled out. Indeed, the accounting revision contemplated by the Financial Accounting Standards Board, if adopted, will serve as a catalyst for such a price war.

In particular, banks and thrifts are likely to aggressively attempt to recapture share of originations, spearheaded by price cutting, as FASB will make mortgage banking far more profitable.

While banks and thrifts have receded from making fixed-rate mortgages because of interest rate risk, they are completely at ease with selling and servicing these loans, and the accounting changes contemplated would greatly enhance the profitability of mortgage banking activities.

Price competition in the originations market could range from an eighth of a point cut in origination fees to three-quarters of a point or more.

Plenty of Leeway

Today, the typical mortgage banker originates at a cost of 180 basis points, charges a fee of 130 basis points, and incurs a loss of 50 basis points to acquire the servicing right, which can be sold for 150 basis points. There is clearly a lot of room to reduce pricing and still leave an attractive return on investment, given that many originators, such as mortgage brokers, have barely any capital requirement to conduct business.

A positive scenario might involve a 25-basis-point price cut, and a 125-basis-point cost deferral by FASB. A negative scenario might entail a 50-basis-point price cut and a 125-basis-point cost deferral.

Since the price cut would apply to all production, while the cost deferral would involve only originations, the negative impact of price competition would outweigh the positive impact of accounting relief.

Further complicating what is soon likely to become one of the more exciting and turbulent periods in the mortgage market will be the sequence with which these events unfold, and impact valuation decisions by investors and the behavior of mortgage market participants alike.

Volume Decline on Horizon

We believe that within a few months, the decline in production volume will begin, given flat mortgage rates, followed soon by price competition and the issuance of FASB's exposure draft detailing methodology.

A vote to implement the changes won't be made before next summer. We would expect to see banks and thrifts begin to expand capacity and become more aggressive in pricing even prior to adoption by FASB.

We would also anticipate that banks and thrifts will acquire mortgage bankers. However, many will hold back, waiting to acquire mortgage bankers at lower prices once the price war and industry consolidation are well under way. While we regard all but Fleet Mortgage as potential merger candidates, North American Mortgage seems to us the most probable target.

All companies would benefit from implementation of the accounting changes, and all would be hurt by price competition. However, individual companies will be affected by these factors to different degrees.

Because Margaretten originates a high percentage of its production and expenses all of these costs currently, it stands to pin the most from a rationalization of accounting standards.

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