With the recent rally taking mortgage rates just beneath 5.60% - considered by some analysts as a critical level for refinancing exposure - there is a renewed discussion in the market place about refinancing risk, particularly with the Freddie Mac 30-year fixed rate dropping to 5.57% last week.

Credit Suisse First Boston Mortgage Strategist Mahesh Swaminathan said that current refinance exposure of the mortgage market as a whole is contained with only about 33% exposed to at least a 50 basis points refi incentive, while 30-year 5.5s (the largest coupon outstanding) now only have a 13% exposure. Swaminathan reported that a critical point prompting a jump in convexity buying would be if 5.5s gain a refinance exposure of above 50%. He also said that a 15 basis points rally from the current 5.57% level on the 30-year mortgage rate would bring 61% of the 5.5 universe into the refinance window, while a 20 basis point rally would result in 84% of 5.5s being exposed. Conversely, extension risk - which brings about convexity related selling - is also currently contained with only minimal drops in refinance exposure expected. Swaminathan said that any extension is likely to be localized at this point.

In terms of the Refi Index, he said that a critical level where prepayment speeds would rise significantly is if the Index breaks the 3000 level and stays there. However, barring this event, he expects increases in prepay speeds for the March to be up approximately 15% to 20% and April increases to be in the single digits in percentage terms. Last Thursday's sharp sell-off in rates correspondingly increases the magnitude of the rally needed to ignite a refinancing event.

Recently, Bear Stearns analysts said that for each basis point that the mortgage rate rallies from the 5.60% level, about $30 billion of MBS become "materially exposed to refinancing incentives." Analysts noted that if the mortgage rate were to dip to 5.45%, the Mortgage Bankers Association Refi Index would increase from the current average of roughly 2200 to approximately 3500.

Bear added that as origination pipelines grow, the resulting increased supply and interest rate volatility could adversely impact passthroughs. Aside from widening spreads, originators and servicers inject interest rate volatility to the market by hedging out their respective mortgage pipelines. On the supply side, analysts also noted the $8 billion rise in outstanding fixed-rate balances last month - the first increase since July. Last year's fixed-rate volume decrease was due to the rise in the ARM percentage. However, Bear said that the flattening yield curve might reverse this trend. Spread tightening resulting from the downdraft in outstanding supply last year along with new demand from Asia could ease as well.

Similarly, JPMorgan Securities noted that origination volumes have risen again and at current rates, analysts are anticipating that the MBA Refinance Index could potentially rise to 2500, the highest reading since April 2004. Additionally, with the mortgage sector currently "enormously" concentrated in the 5.5 coupon, UBS said small rallies can now result in substantial changes in the refinanceability of the market. This is why analysts expect much stronger application readings in the MBA for the weeks to come - above 2500 in the next two weeks.

After 5.60%, Bear's next refinancing threshold would be a 5.25% 30-year mortgage, matching the 2003 record low. In order to match 2003 refi exposure and levels, a sub-5% mortgage rate would need to be reached, said analysts.

Despite discussions of an imminent reversal to a high refi environment, some said that refinancing risks are not as high as they currently appear to be. "Though rates are near their local lows, we believe that the risk of major refinancing activity is not as high as it seems when factoring in the flattening of the curve and the increasing effect of short partial durations," wrote Morgan Stanley analysts.

Although roughly 70% of 30-year mortgages currently have a higher coupon versus the market rate, analysts said these loans are not necessarily refinanceable. The firm said that if a refinancing threshold of 25 to 30 basis points is factored in - which is equivalent to how much "moneyness" is needed for borrowers to consider refinancing - about 40% was found refinanceable. This analysis also suggests that a 25 basis point drop in rates from current levels would make an additional 30% of the market enter the refinancing window.

Morgan Stanley analysts also said that the current flatter yield curve helps mitigate potential refinancings. Data presented by the firm shows that along with 2s/10s, the spread between hybrids and fixed-rate mortgages has been tightening considerably from roughly 150 basis points during last year's low in the 30-year current coupon to about 50 basis points now.

Analysts said that in previous refi waves the availability of significantly low hybrid rates boosted prepayments. However, there is currently a lower incentive to transition from a 30-year fixed into a hybrid. Thus the refi threshold, which is based on the 30-year mortgage rate, would be higher. Morgan Stanley analysts said that loosely speaking, if about 20% of 30-year borrowers in a refi wave move into hybrids, a reduction of the hybrid/fixed spread by 100 basis points could increase the refinancing threshold by an additional 20 basis points, analysts said.

Morgan Stanley added that in the same way the shape of the curve impacts mortgage refinanceability, the reverse could also be true. Analysts explained that the convexity hedging's "feedback effect" at the short end could be considerable. Although the yield curve flattened in the last six months, mortgage durations have also been shortening. "Indeed, a flatter curve, mostly due to the short end selling off, implied lower forward rates and hence faster prepayments in the future," analysts wrote. "This, in turn, means shorter mortgage cashflows."

Copyright 2005 Thomson Media Inc. All Rights Reserved.

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