Currently, 93.1%, or $2.6 trillion, of the fixed rate MBS universe is exposed to refinancing risk at a 5.45% mortgage rate, says Bear Stearns. This level of exposure is similar to that of last October. So what does this translate into in terms of origination and prepayments?

Bear Stearns is currently projecting total mortgage originations of $3.7 trillion and agency issuance of $2.3 trillion. At the same time, the Mortgage Bankers Association (MBA) is predicting that mortgage originations will reach $3.0 trillion versus $2.5 trillion in 2002. The MBA anticipates refinancings to represent 65% of originations versus 59% last year.

On the prepayment side, analysts are predicting speeds to peak in July for most coupons and vintages and then decline very slowly for several months following. The 5.5% coupon, however, is expected to continue to trend higher through October. Bear Stearns says this is the most vulnerable coupon as it is "moving into the refinancing window for the first time ever." The firm also notes that 5.5% coupons have significantly higher loan sizes than same vintage 6s, so "under equivalent incentives, the 5.5% coupon is expected to pay faster than the same age 6.0% coupon."

Refi Index poised to set new record

For the week ending May 16, mortgage application activity was mixed, said the Mortgage Bankers Association. The Purchase Index declined 5% to 396 while the Refi Index jumped 15% to 8351. Analysts were expecting gains in both indexes as rates moved to new record lows. In particular, some analysts were predicting the Refi Index to increase to the 9000 level. As a percentage of total applications, refi activity increased to 76.0% from 72.4%. At the same time, ARM share declined slightly to 12.5% from 12.7%. MBA economist, Phil Colling, said "Interest rates are now at 45-year lows, and consumers are definitely taking advantage of these rates. MBA now expects 2003 to be yet another record year in terms of mortgage originations."

Lehman Brothers noted that when the Refi Index peaked at 9387 in March, mortgage rates were 25 basis points higher than they are now. They attribute the muted response with the increased concentration of the mortgage universe in 5.5% and below coupons. With mortgage rates continuing to drop, however, they anticipate a reading above 9000 before long.

Citigroup suggests that borrowers are waiting on expectations of lower rates. The firm expects the Index to skyrocket if rates decline further (as they have) or back up. At this juncture, prepayment speeds are expected to remain elevated and peak at higher levels than previously anticipated.

As expected, mortgage rates set a new record low for the week ending May 23. As reported by Freddie Mac, 30-year fixed mortgage rates fell to 5.34% from 5.45%; 15-year fixed mortgage rates declined nine basis points to 4.73%; and the one-year ARM rate reported in at 3.61% versus 3.67% last week. This is likely to push the Refi Index to a new record high over the next couple of weeks, possibly breaking 10,000.

Trade du jour: down-in-coupon

With 10-year yields down nearly 40 basis points since early May, investors are focused primarily on 30-year 5% coupons and 15-year 4.5s for reasons including duration, price, prepayment risk, liquidity and carry. Analysts are now mostly neutral to negative on the mortgage sector. JPMorgan Securities cites increased volatility, heavy paydowns and poor Index convexity making for rough sailing in the weeks ahead.

Over the Wednesday-to-Wednesday period, spreads widened with 30-year Fannie 5s moving out four basis points, 5.5s six basis points and 6s seven basis points. The roll has collapsed in 5.5s. Dwarf 4.5s were five basis points weaker over the period, while 5s were out 11 basis points.

Originator selling held at normal levels of between $1 billion and $2 billion per day last week. In addition, originators were actively buying back 5.5% coupons as mortgage rates continued to fall. JPMorgan says there are indications that originator pipelines are beginning to fill with 15-year 4s and to a lesser extent with 30-year 4.5s. At this time, it appears that several billion FNMA 4.5s may be produced for July, they say. This may lead to some originator buyback in 5s at some point.

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