Though market players are not expecting the current dip in rates to cause prepayment speeds to shoot up to last year's levels, the market is still at the point where it could be vulnerable to a massive supply boom in MBS, said analysts.

"The potential for a supply surprise already exists," wrote MBS researchers from Deutsche Bank in a recent report. According to the firm, they had predicted a total net supply of $300 billion fixed-rate agency MBS for 2002 at the beginning of the year. However, supply numbers have already reached $94 billion in the first quarter alone. The bank has since increased its net supply forecast to $350 billion for 2002 (compared to $362 billion for the previous year).

The firm also warned that if one considers the projected supply numbers with weak GSE purchases in March (see related story on p.18) - which amount to only $5 billion compared to $27 billion in January in net purchases - along with declining MBS holdings by banks ($8 billion thus far in 2002) then "the supply-demand picture looks like a problem for MBS."

With these figures, analysts concluded that "the risk appears to be for higher supply, not lower supply as we head into the peak buying months."

According to Morgan Stanley mortgage strategist Yubo Wang, after a 35 basis points of decline in mortgage rates since the beginning of the year, "It will be difficult to remain complacent about supply should mortgage rates continue to hover around sub-7% levels for long, or go even lower."

He added that the steep dip in rates has made the mortgage market more in the money. The 7% coupon - which currently represents 22% of the oustandings--is now refinanceable.

"The fact that about 61% of the outstanding balance is concentrated in 6.5s and lower coupons is a benefit to the mortgage market when rates decline, because for them to be eligible to refinance, mortgage rates need to drop a lot lower," said Wang.

Bear Stearns echoed this analysis when it said that a sub-6.5% mortgage rate is needed to re-ignite the full refinancing engine because borrowers are less inclined to respond to rates that remain higher than what they have been in the recent past.

Supply surprise

Analysts also stated that the decline in rates combined with the large, seasonal rise in home purchases and relocations may further spur the uptick in mortgage-backed supply.

Last week's 14% rise in the refinancing index was accompanied by a sharper rise in the Government Refi Index. This index rose by 38%, up to 258.9 from the prior week's reading of 226.1.

Focus on the Purchase Index

The refinancing numbers are further exacerbated by the continued rise in the MBA's Purchase Index. According to the MBA, the Purchase Index reached a record high for the week ending May 3. The Index rose to 382.7, beating the previous record of 375.9 that was set in early January. Added to this, the Government Purchase Index was up by almost 9%.

In a commentary last week, Lehman Brothers said that the elevated level of the purchase index bears watching. The firm noted that at these levels, the Index is 20% higher than a year ago, while rates are only marginally lower.

"The strength of the housing market continues to surprise, given the continuing weakness in employment rates and the softening in home price growth as revealed in the fourth quarter repeat sales data from FHLMC," wrote Lehman analysts. "What it does mean is that turnover rates on discounts will continue to remain at historically high levels, particularly in the 98-99 vintages."

Meanwhile, JPMorgan analysts stated that as the housing market continues to accelerate, extension risk has remained a non-factor, with the GNMA sector continuing to show less extension compared to conventionals.

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