Mortgages saw a fairly active week with better buying, particularly in the lower coupons, which had cheapened in the previous week on heavy selling from banks. The tone was more supportive than in the previous week, and helped by stable yield levels with the 10-year Treasury holding in the 4.60% area. At this yield area, mortgages had a reprieve as servicers did not need to add duration, and originators didn't need to sell TBAs to lock in spreads on new loans written. Volatility also held low with the fairly stable market. On top of this, the end of the week offered the traditionally supportive events for mortgages - the employment report and September paydowns. Typically, mortgages benefit from the decline in volatility following the payrolls report. Meanwhile, paydowns are estimated at about $40 billion.

Investor participation was widespread and included money managers, fast money and servicers moving up and down the coupon stack, although 5.5s and 6s were most favored. Investors, however, did not ignore the cheapening in 5% coupons, despite the risks of the slowing in the housing market and its impact on prepayment speeds. Asian investors, although not totally absent, were relatively quiet as China was on a weeklong holiday. On the originator side, selling was limited and held to less than its usual $1 billion per day average, although there was expectation of it picking up on Thursday as the market traded lower.

For the first three days of October, mortgages have outperformed Treasurys, according to Lehman Brothers. The MBS Index is up eight basis points so far, bringing the year-to-date outperformance to 69 basis points over Treasurys.

For now, servicer convexity hedging risks have paused, though it is expected to pick up if the 10-year makes a push towards the mid-4.30 area. At this yield level, FNMA 5.5s would move above par, said Alec Crawford, head of agency MBS strategy at RBS Greenwich Capital.

Analysts' sentiment currently is neutral to positive. JPMorgan Securities says the recent rally raises refinance risk and increases the chance of continued bank selling as their "underwater" positions improve - although they are likely to reinvest back into the mortgage market in either higher coupons or mortgage loans. On the other hand, if rates back up, Deutsche Bank warns of significant production coming through the pipeline.

The positives include the outlook for declining volatility, tightening swap spreads, as well as favorable seasonals. According to UBS analysts, seasonality is quite strong in the MBS market. Their analysis noted that the high point of the market is "really a plateau between late February and mid-May," while "the seasonal low point is towards the end of September." Furthermore, they observed that there is a "very strong seasonal uptrend that begins now and continues until late February."

UBS analysts used this information to quantify mortgages' performance based on seasonals. Over the period 9/30/04 through 9/26/06, mortgages outperformed on average by $0.75 over the course of a year, said analysts. Averaging just the six strong months (October to March), mortgages outperformed by $0.83, and underperformed by $0.08 in the weaker period (April to October).

UBS analysis also considered momentum and mean reversion. They said taking all of these three factors into account, "it appears that mortgages can outperform Treasurys by approximately 13 plus ticks over the next 60 days."

Refinance Index surges 17.5%

Mortgage application activity finally showed a noticeable response to the more attractive mortgage rate levels. According to the Mortgage Bankers Association, overall application activity jumped 12% for the week ending Sept. 29 with gains in both purchases and refinancings. The Refinance Index surged 17.5% to 1971, which is in line with expectations. This is the highest the index has been since mid-October 2005 when it was 2096. After declining for two weeks, the Purchase Index rose back above 400 with a 7.6% jump to 404.6.

Mortgage rates were unchanged to one basis point lower this week, according to Freddie Mac's latest survey. With rates remaining favorable, application activity is expected to have increased slightly more this week. JPMorgan, for example, expects next week's MBA report to show the Refinance Index moving above 2000, though remaining below 2100.

Freddie Mac's weekly survey reported that the 30-year fixed mortgage rate fell one basis point to 6.30%. This is the lowest rates have been since early March of this year. Meanwhile, 15-year fixed mortgage rates and 5/1 hybrid ARM rates were unchanged at 5.98% and 6.00%, respectively. And last, the one-year ARM rate also slipped one basis point to 5.46%.

Remarking on the mortgage rate levels, Freddie Mac Chief Economist Frank Nothaft said the jump in refinancing activity last week was due in part to "homeowners who are refinancing ARMs rather than waiting for them to reset in the future when rates may be higher."

"Even though rates have fallen recently, housing activity continues to slow while new construction wanes, leading [Federal Reserve Chairman Ben Bernanke] to expect that the national economic rate of growth will lose up to one full percentage point in the last half of this year, " Nothaft added.

In research last week from JPMorgan, analysts talked about the impact ARM to fixed refinancings would have on the Refinance Index and prepayments for 2007. They believe the MBS Refinance Index could be boosted by 5% to 10% as ARM borrowers nearing their reset look to refinance into alternative products.

"This means that the MBA Refinancing Index of 1700-1800 that we are seeing now could be 1900-2000 next year with no change in rates and no change in agency fixed rate prepayments," JPMorgan analysts said. They calculated there would be $400 billion in resets next year.

Translated into CPRs, JPMorgan analysts estimate the ARM resets could add 3 CPR to speeds in 2007. However, partially offsetting this is the anticipated decline in cash-out refinancings due to the slowing housing market. As a result, "the net effect would be less than a 1 CPR increase in market speeds," analysts said.

Prepayment outlook

The September prepayment reports were released last Thursday evening. As of ASR's press time, speeds were predicted to slow 10% to13% in 4.5% through moderately seasoned 5.5% coupons. Speeds on more seasoned 5.5s through 6.5s were expected to range from 9% slower to 2% slower. The primary reason for the slowing in September was due to three less collection days as well as slowing seasonals. However, the rally in August and into September was offsetting the decline to some extent as refinancing activity had steadily picked up.

(c) 2006 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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