Over the Wednesday-to-Wednesday period, mortgage spreads were slightly weaker as investors moved to the sidelines on the high price levels and focused more on the long holiday weekend. The week saw 30-year Fannie Mae 5s moving out three basis points, while 5.5s weakened one basis point. Ginnie Maes performed slightly better on overseas support, widening just one basis point in 5% and 5.5% coupons. Meanwhile, 15s were mostly avoided despite lagging 30s and Street recommendations. As a result, spreads weakened three basis points.

Towards the end of last week, activity was picking up with increasing retail interest. Banks and money managers were the main supporters for the week. Interest was focused solely on the down-in-coupon into currents. Originator selling remains generally light, averaging about $2 billion per day.

Near-term events/issues confronting MBS

In the near term, events remain supportive for the mortgage market. They include month- end buying support, the employment report and the calendar flip over the next two weeks or so. In addition, there are reports that Washington Mutual is possibly going to move a good portion of its over $50 billion portfolio out of Treasurys into MBS.

The issues confronting the MBS market are increasing prepayments and a dramatic coupon redistribution of the MBS Index. Currently, consensus is calling for a 50% CPR by July on 2002 Fannie 5.5s from 21% CPR in April. Also, 2002 6s are predicted to prepay at 72% in July versus 51% in April, and 2002 6.5s are forecast to hit 75% from 63%.

In recent comments from Lehman Brothers, the firm notes that primary mortgage rates have not declined as much as secondary market prices indicate. They expect that, as mortgage originators add capacity or process this first wave of refinancings, the spread should converge. If this occurs, record high prepayments could be sustained for some period of time.

Regarding the future composition of the MBS Index, Lehman says they expect 30-year 5s to average over $65 billion per month down the line and $40 billion for 15-year 4.5s and lower. Based on this trend, they predict that 30-year 5% coupons and lower would make up 19% of the Index in six months and 29% in 12 months. This compares to 0% currently. Meanwhile, 5.5% coupons would increase to 20% and 23% in six and 12 months, respectively, from 13%. Meanwhile, 6% coupons would fall to 8% in 12 months from 22% currently, and 6.5% coupons and greater would plunge to 11% from 41%.

Lehman says there are two implications from such a dramatic change: (1) as lower coupons replace premium coupons, overall call risk will increase while alleviating extension fears; and (2) it will dramatically increase the vega exposure of the mortgage market and put upward pressure on implied volatility.

Refi Index gains less than expected

Despite mortgage rates moving to new record lows, mortgage application response was muted for the week ending May 23. According to the Mortgage Bankers Association (MBA), the Purchase Index was unchanged at 396, while the Refinancing Index rose 6% to 8841. Analysts were expecting the Refi Index to come in above 9000.

As a percentage of total applications, refinancing activity rose to 77.1% from 76% in the previous report. At the same time, the share of ARM activity increased to 13.4% from 12.5%.

Lehman suggested several factors that kept the Refi Index from rising to over 9000. One was that the spread between primary and secondary market mortgage rates has widened 10 to 15 basis points over the past month. This has kept the full extent of the rally from flowing through and bringing mortgage rates even lower. Also, borrowers are holding back their applications in anticipation of a flattening out in rates. Citigroup suggested some impact of the Memorial Day weekend as potential borrowers may have started their holiday early.

Another point of interest from the report, noted by JPMorgan Securities: almost all of the 6% increase in the Refi Index came from refinancing into ARMs. This implies a continued decline in fixed-rate supply. Looking ahead, Lehman believes the Refi Index will average between 9000 and 9500 over the next few weeks, with a 10,000 print still possible. Citigroup believes next week's Refi Index will drop by 15% to 20% due to the holiday. - Sally A. Runyan/ MortgageData

Freddie Mac reported a new record

low in 30-year fixed rate mortgage rates for the week ending May 30 - 5.31% versus 5.34% the prior week. The 15-year fixed rate mortgage rate was unchanged at 4.73%, also a record low. Lastly, the one-year ARM rate rose two basis points to 3.63%.

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