Better selling continued to plague mortgages last week as the market continued to sell off on stronger-than-expected economic data. The 10-year Treasury yield has backed up 17 basis points in the past two weeks to 4.788% as of the close of Jan. 17. Yield levels are at their highest since late October 2006, but still well off their high of last year of 5.245% in late June.

Two-way flows were focused in 5.5% and 6.0% coupons with better selling from real and fast money, while servicers were better buyers. Asian investors have been a disappointment so far this year with very limited participation. When they have added, buying has been in the fuller coupons as well. Talk is that their bogey levels are set at around 4.80% on the 10-year.

In early trading on Thursday, this level had been hit - albeit briefly - as housing starts were stronger than expected increasing 4.5% in December, while PPI was up slightly more than expected at 0.5%. Core inflation, however, was in line with expectations at 0.2%, and, finally, initial claims declined unexpectedly. Originator selling has averaged slightly over $1 billion, with supply consisting primarily of 5.5% and 6.0% coupons.

The relentless selling is taking its toll on mortgages' performance. Lehman Brothers' MBS Index is now up just eight basis points month-to-date. This is down from more than 25 basis points in the first week of the new year.

Analysts mostly favorable on sector

While mortgages have been subject to better selling, analysts' outlook remains mostly favorable towards the sector. For example, Citigroup Global Markets analysts said they expect performance to remain strong with a preference towards 30-year 5.5s and 6s.

They anticipate an increased presence from non-U.S. and bank investors to pick up after a slow start to the year, and focus on these coupons. Deutsche Bank analysts said last week that they believe demand for carry instruments remains strong. In addition, they noted that spreads in credit sectors are fundamentally tighter than MBS on a historical basis. They expect current coupon MBS could outperform by another three to four ticks versus swaps, adding that they would turn back to neutral if the ZV dipped below 50 basis points.

UBS analysts also said they continued to recommend a modest overweight on the mortgage basis and that the current tight spreads are justified. They expect foreign demand and crossover buying to be robust as well.

Economic/Treasury events scheduled this week

This week brings the first full week of trading for 2007. Economic data is on the lighter side and weighted toward the end of the week. Releases include leading indicators on Monday, existing home sales on Thursday, and durable goods and new home sales on Friday. Other events of interest include a 20-year TIPS auction on Tuesday, and two- and five-year note auctions on Wednesday and Thursday, respectively. Fedspeak starts winding down with the Federal Open Market Committee meeting looming on Jan. 30 and 31, so appearances will be minimal. On Monday, President of the Federal Reserve Bank of San Francisco Janet Yellen will be speaking on the economy, though that may be anticlimactic following Federal Reserve Chairman Ben Bernanke's Jan. 18 testimony before the Senate Budget Committee.

Refis gain, purchases slip

Mortgage application activity was mixed in the week ending Jan. 12. According to the Mortgage Bankers Association, the Refinance Index increased 6.3% to 2045.8 as the index continues to recover from the holiday slowdown. In the past 10 weeks, the index has risen above 2000 three times - the only times in the past year. A year ago, the index was at 1645. Meanwhile, the Purchase Index dropped 7% to 439.7. This is close to its year-ago level of 444. As a percentage of total application activity, refinance share increased to 49.9% from 48.4%. ARM share was also higher at 21.2% from 20.1%.

Freddie Mac reports additional mortgage rates gains. Both 30- and 15-year fixed-mortgage rates increased two basis points this week in response to higher yield levels related to the favorable outlook on economic growth. According to Freddie Mac's weekly survey, 30-year fixed-mortgage rates averaged 6.23% and 15-year rates were 5.98%. A year ago, rates were at 6.10% and 5.67%, respectively.

On the adjustable side, five-year hybrid ARMs were little changed at 6.04% versus 6.03% previously; however, one-year ARM rates jumped seven basis points to 5.51%.

Since bottoming prior to Christmas, refinancing activity has recovered 27%. With rates increasing, refinancing activity could show slowing from the recent strong gains in the upcoming report.

January speeds projected to be little changed overall

Initial expectations for January are for speeds to be little changed overall from December, with slight declines anticipated for discounts, while par and premium coupons are predicted to be flat or up less than 5%. Factors influencing speeds include a higher day count - 21 days versus 20 days in December - and lower mortgage rates with the 30-year fixed rate averaging 6.14%, down 10 basis points from November's average. However, refinancing activity was slightly lower on average at 1880 versus 1919 due to the holidays.

In a report released last week, UBS analysts said that, for January, they expect prepayments on 6s and 6.5s of 2006 production to increase 2 to 3 CPR, which is equivalent to 5% and a higher day count, or in other words, one more business day. It also shows a 10 basis point dip in two-month rolling-average mortgage rates. Analysts said that speeds on new 5.5s should rise by more than 1 CPR, and would be mostly driven by day count. Seasoned discounts could see a slight drop in prepayments, around 3%, as weaker seasonality offsets the increase in day count. Prepayments on seasoned premiums will rise 3% to 5%, resulting from day count as well.

As for February, analysts said that the month could experience a significant drop - 7% to 10% - in speeds considering the two less business days. The rise in seasonality is too small to offset the effect of day count, they said.

Analysts noted that the recent back up in rates could also lessen refinance activities slightly, although they predict speeds on new 6s and 6.5s to be flat from their January levels, as day-count reduction is offset by ramping up the seasoning curve.

Meanwhile, March prepayments are a different story altogether as this is the month "when prepayment fireworks are on full blast," said analysts, explaining that it would only be a "backyard version of fireworks" or a full blast coming from a much more muted level.

A sharp rise in seasonality along with three additional business days will boost speeds over 25%, unless there's a significant sell off from the current rate level, analysts said. Both premium and discount speeds will rise considerably from February levels. The 2006 5.5%, 6% and 6.5% are expected by analysts to experience a speed increase of between 1.5 and 4 CPR. "Even after the 25% increase in prepayments, the overall speed level is still quite low," they said.

(c) 2007 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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