Mortgage players are bracing themselves, as the market inches dangerously close to a another refi wave.

Last Thursday, Freddie Mac said that the average rate on a 30-year, fixed-rate mortgage dropped to 6.92% from 7.0% the previous week. This is the lowest it has been in almost five months.

As of Wednesday last week, Street research said that the current mortgage rate was 6.95%, merely six basis points away from the lows in March.

This has placed rates below what mortgage analysts have called the 7% critical-rate threshold that should revive the current refinancing wave.

The Street was not taking this lying down.

UBS Warburg, for instance, last week cut back its full mortgage overweight recommendation to a modest overweight. Analysts based their recommendation on the good run that the market has had and a more balanced view of where rates could go.

Another rather disturbing event is growing investor disenchantment with the sector as reflected in last week's JPMorgan client survey. The survey showed investor mortgage overweights significantly dropping to historical low levels not seen in the past two years.

Analysts from the bank said that convexity and prepayment-related concerns have come back because of substantially lower interest rates and higher MBS dollar prices.

"At the beginning of the month, we recommended reducing our more aggressive mortgage overweight to a moderate overweight," said Yubo Wang, an MBS strategist at JPMorgan. "Investors seem to be moving in the same direction."

Investor concern is justified judging from the volatile refi environment the market finds itself in. The current coupon as of last Thursday was 6.50%, down from where it was on Aug. 3 when it was at 6.65%. This reflects a 15 basis point drop in just a couple of weeks.

This significant decline has put rates in the neighborhood of the lows seen in late March when the current coupon reached 6.45%.

"The issue here is that we are on the borderline," said Glenn Boyd, an associate director from the mortgage strategy group at UBS. "We are flirting with very low mortgage rates that could re-ignite the refi wave in full bloom."

6.5s and 7s hardest hit

A peculiar characteristic of the next stage of this year's refinancing wave is that its extent would largely be determined by the 6.5% and 7.0% coupons.

According to a Bear Stearns report, these two coupons currently comprise roughly 60% of mortgage-backeds, up from 52% at the start of the year.

Aside from this, analysts say that these coupons have not experienced any burnout thus far.

"The 6.5% and 7.0% coupons have not seen much rate incentive," said Amitahb Arora, vice president at Lehman Brothers.

For instance, he explained that the 7.0% coupon has, for the most part, roughly a 7.60% WAC. This means that this coupon has not seen effective refinancing incentive of more than 50 to 55 basis points in the past six months. Therefor, if rates were to decline another 40 basis points, it would be the first significant incentive the 7.0% coupon would have, and refinancings in this coupon would really take off.

Arora argues that if this happens, the 7.0% coupon would probably prepay faster than the 7.5% coupon (the 7.5% coupon (1999-2000 vintage) has been prepaying on average at 42 CPR for the last three months). Consider also that there is almost two times as much outstanding in the 7.0% coupon relative to the 7.5%. This means that if the 7s prepay faster than the 7.5s, the dollar paydown would be more than two times as much.

Bear Stearns said that all of the 7.0% coupon is refinanceable. The high WAC 6.5s (2000 vintage) enters the refinancing mode at a 6.75% mortgage rate level while the entire 6.5% coupon becomes refinanceable at a 6.5% level. The report said that the overall refinancing exposure level goes up to 87% from 52% between 6.95% and 6.50% mortgage rates.

As rates go down, MBA Refi Index is expected to rise

According to Lehman's report issued last week, researchers expect significant increases in the MBA Refi Index for small declines in mortgage rates as the 6.5% and 7.5% coupons become refinanceable.

Lehman published another prepayment report earlier in the month when mortgage rates were still at 7.05% - Lehman's 30-year mortgage rate based on secondary market prices - exploring how the rise in the MBA Index is related to lower mortgage rates.

Researchers said that with a 7.05% mortgage rate, they expected the MBA Refi Index to be in the 1800 range. If rates fell 25 basis points to 6.80%, Lehman expected the index numbers to rise to 2600; and if mortgage rates went down to 6.55%, the index would go up to 4000.

The market may not be far from the 2600 range. As of close of Wednesday last week, the 30-year mortgage rate (based on secondary market prices) was down to 6.97%.

"If the Index goes up to 2600, we would see a slight increase in total 30-year conventional gross issuance on account of refinancings alone compared to what we've seen in the last three months," said Arora.

Thirty-year conventional gross issuance on account of refinancing has been in the order of $21 billion. If the Index goes up to 2600, gross issuance would likely be about $24 billion while, if the Index rises to 4000, gross issuance would be about $27 billion.

Effect would be different

from first wave

Though the market may once again revisit the peaks of prepayments that it saw earlier this year, the next stage would have different characteristics.

Bear Stearns said that "the impact of the latest move in rates on mortgage portfolio durations and hedging requirements will be less dramatic than at the beginning of the year..."

Analysts said that this is because the market is transitioning from a very fast prepayment environment, and hedging ratios would reflect these speeds. Furthermore, refinancing exposure is less than it was at the beginning of the year. Fifty-two percent of the fixed-rate market is considered refinanceable, as oppose to 59% at the end of last 2000.

The firm said that this backdrop would extend the duration of the current refinancing wave through the end of the year, rather than pushing speeds dramatically from current levels.

Meanwhile, UBS said that going back to March lows (6.89% mortgage rate) should not cause CPRs to equal peak 2001 speeds. Analysts reason that those who were ready to refi at 6.89% already did at that time. Aside from this, housing turnover is now entering the traditional seasonal decline.

However, the bigger factor would still be the refinancing component. Housing turnover generally accounts for only an insignificant decline in CPR, whereas refinancings could cause a considerable CPR increase if rates rally enough.

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