Though the July prepayment report released last week showed never-before-seen speeds in even the lowest MBS coupons, the interest rate environment has changed substantially since then, and prepayment activity should follow suit, analysts said.

"We are transitioning to a completely different environment where the average borrower, after several years of having a very strong refinancing incentive, now has a very weak incentive at best," said Dale Westhoff, senior managing director at Bear Stearns. "We are going to transition quickly to a much more stable, housing turnover driven prepayment environment."

In a report released last Thursday, Westhoff noted that the refinancing exposure of the mortgage market has plunged from 96% to under 40%. This means that the average borrower's refinancing incentive dropped from 145 basis points to less than 20 basis points. Further, the duration of the mortgage market has extended from less than one year to above three years. Westhoff acknowledged that every major MBS investor group experienced a significant shift in the duration of their mortgage portfolios - which was brought about by a concentration of coupons from record refinancing activity. That sent mortgage players running for the exit, exacerbating the recent sell-off.

However, Westhoff believes that the risk profile of the mortgage market has become much more balanced today. He cited factors that would favor the sector, such as supply declining and banks once again reinvesting in mortgages as massive prepayment cashflows come in. Further, prepayments should be much less interest-rate sensitive.

These factors usually lead to spread tightening if rates remain at higher levels. However, Westhoff still expects the market to remain liquidity challenged and volatile in the near term as it digests the significant move in rates.

Arm activity

Though refinancing activity has significantly slowed, one aspect that may push activity going forward is the increased utilization of hybrid ARMs as a refinancing vehicle.

A recent Countrywide Securities report said that the steep yield curve has kept adjustable mortgage rates, specifically for the 3/1 and 5/1 hybrids, comparatively low. This has caused refinancing application activity to be increasingly focused in ARMs. Data presented by Countrywide showed that ARMs now make up over 30% of conforming refinancing applications as well as more than 70% of jumbo refi applications.

The firm said that many borrowers with rates in the 6.25% to 6.50% level have lost the option to refinance into a new 30-year fixed-rate mortgage. But these borrowers still lower their rate by refinancing into hybrid ARMs, especially if they have the chance to put some money into the transactions by paying points, for instance. Countrywide said that this would mean refinancing activity could continue in seemingly out-of-the money coupons such as 30-year 5.5s. This would drive speeds higher than market participants might otherwise expect.

Countrywide also mentioned that in this current environment of significantly reduced refinancing incentives, the amount of purchase activity would become more important.

It may not be over

The prepayment reports last week showed "sharper than expected jumps," said analysts from Credit Suisse First Boston. CSFB said that the significant jumps were recorded broadly across coupons and vintages. They went over the firm's estimates by roughly 4% to 8% CPR on 5.5s through 6.5s.

"We were expecting the report in July to spike up and reflect the peak, but the levels at which speeds came out were surprising to us," said CSFB mortgage strategist Mahesh Swaminathan. He added that it's not clear from just looking at incentive levels what is driving these accelerated speeds.

For instance, 5.5s of 2002 were responding to a 5.25% mortgage rate, implying a 70 basis points incentive on average. Swaminathan said even if you consider that

loan balances averaged

about $165,000,000 to $170,000,000, this does not really justify 61 CPR speed on 5.5s of 2002.

"But to the extent that speeds did come in there, it seems that there must have been a significant amount of activity to entice these borrowers to come in and refinance at these levels."

This would seem to indicate that if another rally were to happen, 5.5s, 6.0s and 6.5s coupons would still be at risk. He pointed out that these three coupons comprise about 80% of the mortgage universe, thus if there is another rally, the market might be significantly underestimating the impact of a prepayment spike in these sectors.

CSFB said that it expects July prepayments to be the peak of the current refinancing wave. The firm predicts prepayments will drop modestly in August, then sharply in September.

Less extension risk

Though extension risk is still an issue in MBS, analysts said the market has gone through the most negatively convex part of the mortgage curve. This is why the next 50 basis points of extension would have less of an effect going forward.

Last Wednesday, Merrill Lynch estimated that the next 50 basis points of extension would probably be worth only 0.6 years on the mortgage index. This is approximately 40% less extension risk than the previous 50-basis point movement in rates. Looking at this in terms of 10-year equivalents, Merrill said that the next 50 basis points would create about $180 billion 10-year equivalents. That is significantly less than the $300 billion on the previous 50 basis points.

The firm also noted that the position on the curve would depend on the mortgage rate, and not on the Treasury rate. For instance, between July 24 and Aug. 4, even though the 10-year moved by just 16 basis points, the mortgage rate actually increased by 48 basis points. This was mostly because of spread widening. Meanwhile, on Tuesday, Aug. 5, mortgage rates remained essentially unchanged though Treasury rates increased by 13 basis points. However, this move in Treasury rates likely caused no added selling pressure because mortgages did not extend, said Merrill.

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