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From trillions back to billions.

Refinances played a historic role in dominating origination activity last year. This year a shrinking refi market still will leave an origination year that winds up third in the all-time volume rankings.

WITH A STUNNING PERFORMANCE in 1993, paced by residential originations hitting nearly $1.1 trillion, the mortgage industry set a record that will be hard to break in the coming years. Surging refinancing, stimulated by the lowest mortgage rates in more than 20 years, accounted for more than half of last year's mortgage originations. It was the first time that refinancing overwhelmed housing transactions as the leading cause of loan originations.

For 1994, however, refinancing will weaken substantially, although housing activity is expected to strengthen further. All told, 1994's originations will drop by a substantial $200 billion. But this decline, considering the towering starting level from which the drop-off will occur, is not entirely undesirable. After a hectic year of producing, mortgage lenders can now enjoy the fruits of their labor. More than one-third of the outstanding mortgages now carry historically low rates. A great majority of these loans will stay in servicing portfolios for a long while, providing a steady stream of servicing income. However, mortgage lenders will have to make necessary staff adjustments to reconcile the sizable cutback in new originations.

Also, in 1994, lenders need to be more cognizant of the potential widening of mortgage-to-Treasury yield spreads. Despite voluminous originations during the past three years, net demand for mortgage credit has been weak due to a housing recession and the stalled recovery that followed. Weak net demand for mortgage credit sustained tight yield spreads. Now that the housing industry is poised for a sharp rebound, it will significantly raise the net demand for mortgage credit. While the gross issuance of fixed-rate mortgage pass-throughs will decline, net issuance will increase. Look for the spread between current-coupon Ginnie Maes and 10-year Treasury bonds to widen to an average of 110 basis points in 1994.

A breakdown of 1993 originations

Mortgage originations amounted to an estimated $1.094 trillion in 1993, thanks to the rampant refinancing stimulated by the lowest mortgage rates in more than 20 years. The 1993 volume exceeded the record established just the year before by more than $200 billion. As shown in Figure 1, mortgage originations facilitate two types of activity: housing transactions and refinancing. For the first time ever, refinancing in 1993 accounted for more than one-half of total residential originations. Constrained by a stalled recovery, originations for sales transactions of new and existing homes grew only moderately. Figure 1 and its footnotes provide in detail the estimated components of total origination volume for 1993. These estimates are based on several facts and observations. First, published data on housing starts, existing home sales and average sales prices of new and existing homes for the first 10 months indicates that originations due to housing transactions for the year amounted to roughly $495 billion (Item 22). This number assumes a national average of roughly 75 percent loan-to-value ratio. Second, the data through the first 10 months of 1993 also suggested $520 billion (Item 13) worth of gross issuance of agency-guaranteed and private-label, fixed-rate pass-throughs for the year. Third, from this issuance figure along with the known prepayments of $445 billion (Item TABULAR DATA OMITTED 15) and outstanding balances of fixed-rate pass-throughs in 1992 (Item 12) and 1993 (Item 11), the amount of 1993 originations due to refinancing is estimated at $600 billion (Item 23).

FHA's big rebound

A few developments in the components that make up 1993's originations were significant. First, the reform and revitalization of FHA's single-family program markedly expanded FHA originations. This was reflected by the 50 percent increase--to $125 billion (Item 26)--in the issuance of Ginnie Maes, which are now virtually the only secondary market outlet of newly originated FHA/VA loans. Second, despite the fact that gross issuance of fixed-rate pass-throughs amounted to a new record high of $520 billion, they still represented only two-thirds of the $775 billion total fixed-rate conventional mortgage originations (Items 13 and 28). As the differentials between short- and long-term interest rates widened increasingly during most of 1993, some mortgage lenders are suspected of having returned to the old risky arbitrage: borrow short and lend long. There were an estimated $174 billion long-term, fixed-rate mortgages originated but not sold by mortgage lenders in 1993. Normally, newly originated fixed-rate loans are either sold to investors through securitization (sold in the secondary market) or simply sold to Fannie Mae or Freddie Mac. Third, to a lesser extent, even Fannie Mae and Freddie Mac engaged in this yield-curve arbitrage. Their purchases for their own portfolios increased about $30 billion to a combined $105 billion.

Significant drop in refinancing

In 1994, total origination volume is expected to decline by about $200 billion due to the subsidence in refinancing. The expected further recovery in housing activity will offset moderately the sizable drop in refinancing-related originations. The weakening refinance activity will stem primarily from the changing composition of mortgages carrying various interest rates. Because 1993 originations amounted to $1 trillion, one-third of the currently outstanding mortgages carry interest rates at or close to their 25-year lows. These new, market-rate mortgages are unlikely to be prepaid in the next few years--due either to refinancing or to housing transactions.

Thus, even if current mortgage rates and refinancing incentives persist, the shrinking universe of "refinanceable" mortgages will yield a much smaller origination volume. For example, at year-end 1992, there were nearly $90 billion of outstanding 30-year GNMA securities carrying a 9 percent coupon. TABULAR DATA OMITTED The rapid refinancing during 1993 depleted the outstanding balance of Ginnie Maes with a 9 percent coupon. By year-end 1993, the outstanding balance dropped down to $50 billion. Thus, even if this coupon continues to be refinanced at an annual rate of 45 percent, originations due to refinancing of this coupon alone will drop $18 billion.

Back to longer servicing life

One welcome aspect of shrinking originations is the lengthening average life of servicing portfolios. With a marked shift toward market rates in the composition of the pool of outstanding mortgages, one-third of home loans will have the longest expected average life. The rapid runoff of mortgage lenders' servicing portfolios in the past few years will now slow down remarkably. This will provide a much steadier servicing income stream to mortgage lenders and substantially increase the market value of servicing portfolios. While enjoying longer lasting servicing portfolios, mortgage lenders also will have to reconcile themselves to the substantial cutback in originations and curtailed staffing needs. Origination volume in 1994 will be similar to that of 1991 and 1992. This almost means that the entire staff expansion that many businesses experienced during hectic 1993 will have to be rolled back.

A boost in purchase originations

Housing-related originations in 1994 will rise to $530 billion, or 62 percent of total originations. This increase will come from both single-family housing starts and existing home sales rebounding to their strongest levels since 1978. Single-family starts are expected to reach 1.2 million and sales of existing homes to top 3.9 million. Already, toward the end of last year, the housing market signaled the potential of a sharp rebound from its stalled recovery level early in the year.

Strengthened housing activity will raise the net demand for mortgage credit. In general, net demand for mortgage credit is generated through home purchase originations, not refinancing. For housing starts, the net demand for mortgage credit is virtually the entire financed amount. For existing homes, however, the net demand is just the difference between the balance of the old mortgages that are paid off by sellers and the new mortgages that are taken out by homebuyers. In times of robust housing activity with rising prices--such as is expected for 1994--the net demand derived from the existing home market can be significant. For example, as shown in Figure 1, the estimated net increase in fixed-rate mortgage pass-throughs in 1993 is $75 billion. Because fixed-rate pass-throughs accounted for about 42 percent of 1992's total outstanding mortgages, the net increase in demand for mortgage credit in 1993 is estimated to be $177 billion. (This estimate is actually in line with the Federal Reserve's flow of funds data.) For 1994, the net issuance of fixed-rate pass-throughs will rise to $105 billion, despite the projected decline in gross mortgage originations. Based on the estimate that in the beginning of 1994 fixed-rate mortgage pass-throughs will account for about 40 percent of the total outstanding mortgages, the net increase in mortgage credit demand will be $262 billion. Widening mortgage-to-Treasury spreads

The substantial increase in the net demand for mortgage credit and the net increase in fixed-rate pass-throughs in 1994 will markedly widen the yield spread between newly originated mortgages and Treasuries. The mortgage-to-Treasury yield spread reflects the relative price of mortgage credit. As demand for mortgage credit increases, other things being constant, the price of the credit will rise. That is, mortgages have to yield incrementally higher in relation to Treasuries to attract funds. This increase in the price of mortgage credit is reflected in the wider mortgage yield spreads over comparable Treasury securities.

Additionally, mortgage yield spreads will widen if the Treasury yield curve flattens. As the economy gradually gains strength, short-term rates are likely to be under greater upward pressure than long-term rates. This will flatten the shape of the yield curve. As the yield curve flattens, mortgage lenders, or even Fannie Mae or Freddie Mac, for that matter, will be less prone to arbitrage on the yield curve. The practice of holding newly originated fixed-rate mortgages in the portfolios of lenders and agencies will decline. This will raise the funding pressure of mortgages in the secondary market and further widen mortgage yield spreads.

The benchmark mortgage yield spread--the yield differential between current-coupon Ginnie Maes and 10-year Treasuries--will widen in 1994 to an average of 110 basis points. Although originations have been voluminous over the past three years, net demand for mortgage credit has been abnormally low, hovering around $170 billion. The benchmark yield spread over this period, therefore, has been historically tight, averaging 86 basis points. The 48 percent increase in the net demand for mortgage credit to more than $260 billion that is expected in 1994 will widen yield spreads back to levels that prevailed in the late 1980s.

Joseph Hu is senior vice president and director of mortgage research at Oppenheimer & Co., Inc., New York City. The opinions expressed in this article are those of the author and not of Oppenheimer & Co., Inc.
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Author:Hu, Joseph
Publication:Mortgage Banking
Date:Jan 1, 1994
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