Mortgages struggled last week as the market continued to sell off.

Since the end of February, the 10-year Treasury has increased nearly 20 basis points, which has led to an uptick in volatility and duration shedding from servicers. So far in March, the MBS Index has lost 36 basis points in excess return, according to Lehman Brothers, leaving year-to-date performance at 49 basis points over Treasurys. At the end of February, the MBS Index had recorded 85 basis points in excess return versus Treasurys.

Last week started off with nearly $5 billion in selling from servicers and originators. Mortgages continued to lag on Tuesday despite $34 billion in paydowns available for reinvestment. Also negatively impacting mortgages was the softening in the FNMA 5 roll. The sector started to settle down mid-week as the market stabilized, and in early trading on Thursday there was better buying as investors took advantage of the recent cheapening and anticipated drop in volatility following Friday's employment report.

Last Thursday offered pool notification on 30-year conventionals. The FNMA 5 roll was collapsing to carry, while 5.5s were slightly special. The near-term outlook for mortgages is generally seen as directional: holding relatively firm if the market holds stable to tighter, and widening on sell-offs as fears of servicing selling increase.

Mortgage underperformance'

However, in research from UBS, analysts believe "mortgages have seen most of the underperformance they are apt to see."

It was observed that the recent poor performance was a function of the swap spread widening and increasing volatility.

UBS analysts note that swap spreads are near their widest levels in 2.5 years. The range for the 10-year swap has been 36.5 to 57.75, and the level as of the reporting date was 55.5 basis points. The two-year swaps were at 2.5 basis points of their wides, while five-year swaps were five basis points off. This suggests to UBS that, "swaps have limited room to widen further, taking out one major factor contributing to mortgage underperformance."

Volatility is fair-to-high, reports UBS, relative to model values. Its model calculates 1x10 swaption volatility at 5.33 basis points per day, which is where it is currently. The 3x10 swaption volatility is calculated at 5.47 basis points per day. However, its actual value is 5.66.

"The next time the 10-year note touches 4.8%, mortgages will be tighter than they were on the morning of 3/7/2006. Moreover, a stabilization of swap spreads and volatility will be a plus' for the mortgage product," according to UBS.

Another point UBS discussed was the extension risk in the market. While mortgages will extend if the market sells off, analysts believe that is less of an issue for the sector than contraction risk is in a rally. They calculate the extension risk profile of agency mortgage investors to be an increase of $209 billion in 10-year equivalents, assuming a 50 basis point increase in rates, versus a $292 billion contraction if rates decline 50 basis points. These numbers are based on the total size of the mortgage market, not the amount that is hedged, which UBS says is around 10%.

Mortgage application

activity rises 0.7%

Mortgage application activity was up slightly for the week ending March 3. According to the Mortgage Bankers Association, the Purchase Index was little changed at 399 versus 401 on a seasonally adjusted basis. The Refinance Index rose 2.6% to 1614. However, unadjusted it jumped 14%. Overall, activity was lower than expectations.

Freddie Mac reported an increase in mortgages for the week ending March 10, in response to the recent sell off. The 30-year fixed rate mortgage rate averaged 6.37%, up 13 basis points from the previous week. Freddie Mac said this is the highest level since 6.44% on Sept. 5, 2003.

Meanwhile, 15-year fixed mortgage rates increased to 6% from 5.89% previously. This is the highest it's been since July 15, 2002, when it hit 6.03%. On the adjustable side, 5/1 hybrids gained six basis points to 6.03%; and one-year ARM rates rose to 5.45% from 5.34%. The one-year ARM rate is at its highest level since 5.58% on Sept. 21, 2001.

Given the increase in mortgage rates, expectations are for application activity to decline with the Refinance Index moving back below 1600.

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

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