After strong buying over the first three days following the Federal Reserve's announcement that it had started to buy agency MBS, flows turned more balanced. The average price of the MBS market stands at just under a $104 handle and is up against increased resistance as rates rally further.
A sharp flight-to-quality rally in the first half of the week led the 10-year Treasury higher by two points through midday Wednesday, bringing the yield to 2.19%, while FNMA 4.5% prices were down 10 ticks. While the Fed continued to buy an estimated more than $3 billion per day on average, money managers, pension funds and banks more often took profits.
Meanwhile, Asian investors continued to add GNMA 4.5s and 5s, although they were flirting a bit with conventional 4.5% on Wednesday. Supply was also heavy at between $2.5 and $3 billion per day in the first half of the week, split about equally between 4s and 4.5s.
According to Barclays Capital, mortgages remain in positive territory - 100 basis points over Treasurys month-to-date through Jan. 13, which changed only slightly compared with the first four days of trading for the month. However, the MBS Index is lagging ABS, which has surged 465 basis points, and corporates, which are up 157 basis points so far this month. CMBS, meanwhile, have turned south and are underperforming by 132 basis points.
In other mortgage-related activity, dollar trading was less active with rolls a bit softer; 15s were in line to outperform 30s; up-in-coupon outperformed - especially 6.5s as higher coupons benefit from no supply and credit impairment, which is limiting prepayment increases; and GNMA/FNMAs were lower.
Mortgage Applications Rise
Mortgage applications increased as a result of a jump in refinancings. Activity was expected to move higher once the holidays have passed and in response to further improvement in mortgage rates.
The Mortgage Bankers Association (MBA) reported that the Refinance Index surged 25.6% to 7414 in the week ending Jan. 9. Refinance activity remained at its highest level since late June 2003. Meanwhile, the Purchase Index, which had gained over the last two weeks of December, dropped 14.1% to 295.8.
As a percent of total applications, refinancing share jumped to 85.3% from 79.8% in the previous week. ARM share also increased to 1.1% from 0.9%.
The improvement in refinancing activity came on an 18-basis-point drop in the 30-year fixed-rate mortgage rate average to 4.89%. The MBA said this is the lowest recorded average in the survey's history. Previously it had been 4.99% hit in mid-June 2003. The one-year ARM average contract rate was at 4.63% compared with 4.67% in the last survey.
Mortgage/Prepayment Outlook
MBS analysts were more neutral on MBS versus Treasurys last week. JPMorgan Securities analysts noted that, as spreads have approached long-term average levels and gross supply could pressure current coupons, they have turned tactically neutral on the mortgage/Treasury basis.
Deutsche Bank Securities analysts also said the company was remaining neutral on the mortgage basis. In addition, they warned that MBS are caught in a trap where any further rally would cause considerable real money selling, particularly by banks, based on fears of increased refinancing. Analysts warned that it is possible that the overwhelming mortgage supply in a further rally "is sowing the seeds of a violent subsequent selloff in the market" at a time when the Fed would be closing in on its $500 billion purchase amount.
With the drop in mortgage rates and surge in refinancing activity in December, expectations are for prepayment rates to surge in January. Freddie Mac's 30-year fixed mortgage rate averaged 5.29%, down 80 basis points from November's average, while the MBA's Refinance Index soared 188% over November's average.
Prepayment speeds are expected to increase 138% on average in 5s through 6.5% - an 11 CPR increase. Further, speed increases for our sample vintages in 5s through 6s are all anticipated to increase more than 100%, while 6.5s and 7s will see smaller percentage increases. The sharpest increases are projected in 2007 and 2006 vintages.
At this time, February speeds are estimated to increase close to 50%, while March gains are slight. For March, speeds currently are seen little changed to slower in 5.5s and higher, while 5s and 4.5s will experience the largest increases.
Merrill Lynch analysts said it will likely take a few months for speeds to reach their peak levels. This is partly related to the limited capacity at this time at mortgage lenders. Speeds are also not expected to reach levels experienced in 2003 because of the tight underwriting environment at this time. Merrill analysts, for example, noted that with full refinancing incentive, mortgage prepayments have historically come in around 65 CPR.
However, the high-LTV restrictions will likely reduce these peak CPRs quite notably - to around a mid-to-high 40 CPR area for 2006-2008 vintage 5.5s and 6s, while FN 6.5s could be capped at 36 CPR, suggest analysts.
Barclays Capital analysts expect that at current mortgage rates of around 5.25%, speeds will peak at 30 to 40 CPR compared with the over 80 CPR levels seen in 2003. If mortgage rates drop to 4.5%, they expect that speeds will peak at 50 to 55 CPR.
Despite historically attractive mortgage rate levels, speeds are restricted by a number of factors, including a reappraisal requirement that is prohibitive for borrowers who are underwater in their mortgages, the high guaranty fees and the current reduced mortgage lender capacity, as well as the wait by many borrowers for mortgage rates to decline further.
What would really stimulate speeds is easing of underwriting conditions, such as the reduction or elimination of g-fees and removal of the reappraisal requirement for streamlined refinancings. Under these assumptions, Barclays analysts said that peak speeds could reach 50 to 55 CPR at a 5.25% mortgage rate level, and possibly up to 65 to 70 CPR at a 4.5% rate.
GNMA speed increases are more moderate at around 50% higher from December. Barclays analysts attributed the prospect of a more modest increase versus FNMAs to the fact that speeds spiked in December - more than twice as much as conventionals. Analysts noted that because of streamlined refinancing for FHA-to-FHA loans, GNMAs are able to react quicker to rate rallies.
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