Last week was a big week for mortgages, sources say, as Federal Reserve Chairman Alan Greenspan's comments focusing on price stability and an encouraging CPI number removed some of the extension concerns in the market, causing a broad-based bid for mortgages late in the week.

"Greenspan indicated a limited series of tightenings rather than a whole program," said an MBS trader. "There was a lot of fear the week before that things were out of control with the Fed tightenings coming up. People had visions of 1994 dancing around in their heads. But now the CPI number and Greenspan's comments relieved some people's anxieties."

Still, most market players agreed that the mortgage market has become very thin, and liquidity remains a major concern. Traders reported that investors were looking to move into something more liquid, such as shorter, cleaner paper, and anything that is not exposed to prepayments. Because of this, sources say that mortgages might have suffered a bit, as investors try to get their hands around more stable paper.

"Every single one of our customers is acutely concerned with the liquidity in the market," said Michael Youngblood, managing director of real estate research at Banc of America Securities. "Our agency trading desk is very frustrated with the thinness in the market and our inability to transact in size."

Additionally, the response to the CPI "was anything but unanimous," Youngblood added. In the two days following the number, the market had rallied only 8/32nds.

Dale Westhoff, an MBS researcher at Bear Stearns, noted that later in the week, however, mortgage bonds kept pace with Treasurys and even outperformed them, he said.

According to Westhoff, even though the market rallied, it will not trigger another refinancing wave because "we are so far off our lows on prepayments." Instead, investors are confident that they are entering a more stable prepayment environment.

"In the last few weeks, MBS had been widening, and there was a very choppy and illiquid market where relatively small trades were moving the market," Westhoff said. "Today it reversed itself, with lots of buying, particular 7.5% coupons. People got comfortable with the idea that a bond with a seven-year average life won't extend to a 10-year average life any time soon."

Still, even though the MBA refi indexes indicate that they will slow, Youngblood says that the market has yet to catch up with the likely direction of prepayments. Empirical durations still lag option-adjusted or model durations: Current coupon Fannie Mae MBS have model durations of six years, whereas empirical durations are 3.5 years.

"Because of this discrepancy, we feel that wider mortgage spreads are ahead of us," Youngblood said. "Our guess is that mortgage spreads can widen by as much as 14 basis points if they fully reflected the coming slowdown in prepayments."

Though mortgage rates spiked this week, hitting 7.65% for 30-year fixed-rate mortgages, they began to fall off after the CPI was released, and market players predict they will hover around the 7.5% range for most of the summer. If anything, the market has hit the summer doldrums early.

"The Street is running scared," Youngblood said. "Nothing Greenspan said [last week] helped greatly. The next opportunity to see our volatility recover is after Labor Day.

"It is an open question as to whether liquidity will return or not." - AT

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