Oops, the MBS market might do it again

With the 10-year Treasury rate perched on the cusp of the 4% level and with the zero-point 30-year rate currently below 6%, the mortgage market is once again on the verge of prepayment volatility.

In a recent report, Countrywide Securities looked at the impact of the recent rally on the prepayment speeds going forward, if rates stay at their current levels for a period of time.

Consumer mortgage rates are comparatively low compared with levels in the Treasury market. Countrywide cited two major reasons for why rates are so low relative to historical norms: the tightness of passthrough spreads and the relative tightness between primary and secondary rates.

The spread between these two rates usually reflects the competitive pressures in the consumer mortgage market, which has been caused largely by capacity issues. Beginning in the fall, activity levels have decreased significantly as the refi boom waned.

Countrywide said that for consumer mortgage rates to return to historical levels relative to other market sectors, spreads on MBS would need to widen simultaneously with primary/secondary spreads expanding. If the 10-year moves considerably below the 4% threshold, the firm expects these spreads to widen significantly. However, since secondary spreads are quite dependent on activity levels and capacity utilization in the mortgage industry, activity would need to rise above a certain threshold for capacity to be constrained again.

Refinancing activity levels have been very insensitive to interest rates in the last few months, they also noted. This is why the question of what level of interest rates could spur refi activity higher becomes important. Though there has been an uptick in refinancing applications consistent with a Refi Index in the mid- to upper 2000 area earlier, it is still not clear a 4% breach in the 10-year would ignite activity.

"This is critical for mortgage rates, in our view, since we don't expect industry capacity to be strained until the refi index approaches the 5000 level," wrote Countrywide. "Only then would we expect primary/secondary spreads to widen, contributing to the stickiness' of mortgage rates that was exhibited last spring."

According to data that Countrywide presented, with the Freddie Mac survey rate at 5.66% (as of Jan. 16), approximately $765 billion in 30-year passthroughs had a fixed-rate refinancing incentive, given a 35 basis point minimum refinancing threshold, as indicated by the face value of loans with a 6% or higher WAC. This is only 14% higher compared with the value of passthroughs with a 6.25% or higher WAC. This signals that the latest downward move in mortgage rates did not bring a significant part of the market "in the money." However, a downward push in rates to where 5.75% and higher WACs have a refi incentive puts roughly $1.1 trillion face value of 30-year passthroughs in the money, suggesting that major portfolio rebalancing would take place if 10-year Treasury yields pushed through 3.85%.

Countrywide also mentioned that a sustained downward movement in rates should cause an uptick in prepayment speeds for cuspy coupons. With the Freddie Mac survey rate as a proxy, approximately $243 billion of conventional 5.5s have an incentive ranging from 21.5 to 34 basis points. Countrywide said that this should push prepayment speeds of conventional 5.5s older than 15 to 18 months from the mid- to upper teens to the 25% to 30% CPR level.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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