Last week started off slowly as the market waited for Tuesday's FOMC meeting, but once the statement was out, activity picked up and held steady through the rest of the week. Solid buying was observed from money managers, hedge funds, servicers, insurance companies and banks. Buying was across all coupons and was influenced by investor preference for either carry or yield.

Originator selling, meanwhile, picked up from its rather lethargic levels of late. Strong selling totaling in the $2 billion area was noted on mid-week, while Thursday's level totaled roughly $1 billion. Selling is seen increasing from recent low levels on an uptick in mortgage application activity, due to declines in mortgage rates.

Also declining last week was volatility, which slipped after the FOMC's announcement, leading to a slight increase in yields. One trader commented that with the current uncertainty in the market regarding a September rate hike, vols seemed to be a bit low. On the other hand, he acknowledged that given the current range trade, volatility is also limited to the upside. Given this, the up-in-coupon trade will likely to continue outperforming.

Given the supportive tone last week, spreads were tighter. In the 30-year sector, for example, spreads tightened one basis point for Fannie Mae 4.5% to 5.5% coupons over the Thursday-through-Wednesday period. Meanwhile, 6s and 6.5s were three and four basis points richer, respectively. In 15s, spreads were two basis points tighter with the exception of 5s, which tightened just one basis point.

A mid-week MBS recommendation upgrade to neutral from underweight by JPMorgan Securities included a short-term positive slant on short covering. Analysts also prefer 30s over the 15s. UBS raised its weighting to a modest overweight from neutral as well. The recent rally is not enough to change the supply outlook, the firm said, and it's less concerned with increased volatility risk, now that the July employment report and August Fed meeting are history.

Mortgage application

activity mixed

Mortgage application activity was mixed for the week ending Aug. 6, according to the Mortgage Bankers Association (MBA). The Purchase Index slipped 3% to 440, while the Refi Index was 2.5% higher at 1641. As a percentage of total application activity, refinancings were 37.2%, up from 35.8%. ARM share also rose to 34.2%, from 33.5%.

Fixed mortgage rates dropped moderately for the week ending Aug. 13, as Freddie Mac reported that the 30-year fixed-rate mortgage rate declined 14 basis points to 5.85%. It's at its lowest level since early April. At the same time, the 15-year fixed rate came in at 5.24% versus 5.40% the previous week, while the one-year ARM was unchanged at 4.08%.

Given the sharp decline in mortgage rates, mortgage application activity is expected to pick up. Lehman Brothers predicts the Refi Index will increase to 1800 from 1641 this week, while the more aggressive JPMorgan is calling for a level in the 2000 area.

This latest response is not likely to show up in prepayments until at least the September report. However, declines in mortgage rates in July will lead to higher prepayment speeds in the August report with sharper gains expected in September. At this time, UBS predicts speeds on 2003 5s to prepay at 11% CPR in August and 12% CPR in September versus 10% in July. More noticeable increases are anticipated in 2003 5.5s with speeds at 19% and 24%, respectively, in August and September, compared with 16% in July. Finally, 2003 6s are called at 30% CPR and 36% CPR versus 25%. UBS believes October levels will be somewhere in between August and September levels.

What are the refi and

convexity risks?

The rally following the July employment report has brought attention back to refinancing risk and market convexity needs. On both fronts, the news seems rather benign at this time. UBS estimated about 35% of the 30-year FNMA universe is marginally refinanceable, with 24% of the market fully refinanceable. These levels are just marginally higher than July's averages and still down substantially from March 2003's levels of 71% marginally and 42% fully, analysts stated. To get to this level again, UBS calculates that mortgage rates would have to fall 48 basis points, while the 10-year Treasury yield would have to decline 58 basis points.

In terms of the market's convexity needs, although they have increased significantly over the past few weeks, UBS said the effect of these on the market has been muted (see related story, p.15).

As of the previous Friday's close, researchers estimate the convexity hedging needs of investors totaled $48 billion in 10-year equivalents; for servicers, $34 billion; and for originators, $47 billion. UBS added that in the previous two weeks, the convexity hedging needs of market participants have gone from $109 billion in 10-year equivalents per 50 basis points change in rates to $128 billion.

FNMA prepays in line with expectations; GNMAs faster

The Fannie Mae prepayment report came in pretty much as expected. However, Ginnie Mae speeds declined much less than expected. Speeds on Ginnies were also predicted to slow around 20% for 5% through 6% coupons, and in the 15% area in 6.5s and 7s. Instead, speeds slowed 5% to 10% for most coupons and vintages, and held flat in 2003 5s. In general, the Ginnie Mae sector has declined in terms of its credit quality in the last several years. This is due to GSEs having targeted prime lower-income borrowers for initial loans and also upon refinancing, especially given the strength in home price appreciation in recent years. This has left Ginnie with lower-credit quality borrowers, resulting in higher delinquency and default rates and leading to increased servicer buyouts.

Given the last two employment reports and resultant rally, investors may be wondering at what point could prepayments become an issue again. Bear Stearns says the next important refinancing threshold for the mortgage market is a 4% yield on the 10-year Treasury.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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