The rally from the government's rescue plan to buy troubled assets did not carry over into last week's trading. As the markets opened Monday, uncertainty regarding details of the plan as well as its impact on inflation and the economy replaced the initial euphoria. The dollar sank and crude oil jumped $16 to just under $121 a barrel, causing equities to tumble 373 points and the 10-year Treasury to fall 15+/32nds on the prospect of higher supply.

Mortgages were impacted as well by the unwinding of Lehman Brothers' counterparty exposure. This led to better selling by real money and others, particularly in 6% coupons. In below-normal volume, MBS spreads ended near their widest levels of the day with 5s wider to the curve by 18 ticks, 10 on 5.5s, seven on 6s and five on 6.5s. Versus swaps, spreads ranged from 14 ticks weaker in 5s to three in 6.5s.

Tuesday began the first of a round of hearings on the government's $700 billion Troubled Asset Relief Program (TARP). The reception before the Senate Banking Committee was not welcoming. Senators were concerned about the cost and whether it would fix the problem, how the mortgage assets would be purchased, why the government couldn't have stakes in the companies that participate, why the money couldn't be doled out in tranches and generally the overall lack of details, just to name a few of the issues raised. The members were also resistant to the idea that a bill is needed within the week. Members on both sides of the aisle expressed strong concerns about the plan.

Tuesday also saw some strengthening in the flight-to-quality to the short end, T-bill rates declined with the three-month yield at 0.9%, the one-month Libor rate up 22 basis points to 3.44%, the two-year swap spread near a record wide of nearly 136 basis points, 2s10s curved steeper to 173 basis points from 163 basis points at the previous Friday's close, and the Dow was off another 165 points.

Mortgages opened wider to the curve by about seven ticks in 5s through 6s but began to tighten as the hearing got underway mid-morning. Heavy buying began to emerge in these coupons by money managers and hedge funds and pulled spreads tighter by nine and seven ticks in 5s and 5.5s, and nearly twice as much versus swaps by midday. After that, selling reemerged from this same group along with servicers as senators began questioning the plan. MBS ended the day wider to the curve by two to three ticks, and tighter to swaps by five ticks in 5s to one tick in 6.5s.

Wednesday had another round of hearings with Federal Reserve Chairman Ben Bernanke appearing solo before the Joint Economic Committee (JEC) in the morning and then in the afternoon with Treasury Secretary Henry Paulson before the House Banking Committee to talk about The Future of Financial Services: Exploring Solutions for the Market Crisis. In his testimony before the JEC, Bernanke warned of very serious consequences to the economy if the government fails to support the proposal to buy illiquid assets from financial institutions. He said he believes this will help restore confidence in the financial markets and allow banks and other institutions to raise capital and to expand credit to promote economic growth. The prepared testimony of Bernanke and Paulson before the House committee was similar to what they said before the Senate Banking Committee on Tuesday. Bernanke and Paulson did not get a better reception with this group, and it appeared that opposition was growing to the plan. For example, Senator Richard Shelby (R-AL) said in an interview that he would likely vote against the bill. Meanwhile, Senator John McCain said he would temporarily suspend his campaign for President and return to Washington to focus on the crisis. "I do not believe that the plan on the table will pass as it currently stands, and we are running out of time," McCain said. He urged Senator Barrack Obama to return to Washington as well and has asked for Friday's Presidential Debate to be postponed.

The flight-to-quality continued with the three-month bill yielding less than 1/2% and the one-month bill falling below 0% briefly as investors remain anxious about the government rescue bill. In addition, the two-year swap spread had jumped to nearly 149 basis points by midday Wednesday. The 10-year Treasury was also benefiting from the flight-to-quality with the note up 15/32nds at noon with the yield 5.7bps lower to 3.788%. In addition, 2s10s were at 174bps, one basis point steeper from Tuesday's close.

Mortgages opened three ticks wider to the curve (two ticks versus swaps) in 30-year 5.5s and steadily widened into midday to nine and three ticks, respectively. Volume was relatively light with better selling, given the uncertainty of the $700 billion rescue plan, and increased flight-to-safety to the very short maturities.

In other mortgage-related activity through midweek, Asian investors remained on the quiet side, 15/30s were mixed, GNMA/FNMA were little changed to slightly tighter, dollar rolls were weaker and supply averaged about $1.25 billion per day. MBS volume was below normal in the first half of the week due to the uncertainty regarding the government's plan as participants focus on the hearings.

Month-to-date through Sept. 23, Lehman's MBS Index was outperforming Treasurys by 84 basis points, but this is down from +114 basis points through Sept. 19. Mortgages, however, continue to lead the various cross-sectors: ABS, negative 46 basis points; CMBS, negative 129 basis points; and corporates, negative 440 basis points.

Mortgage Applications Fall

Mortgage application activity declined for the week ending Sept. 19 as mortgage rates moved higher on the turmoil associated with Lehman's bankruptcy, the American International Group takeover by the government, the money market fund run and the Treasury's announcement for a Resolution Trust Corp.-like solution to buy troubled mortgage assets.

The Mortgage Bankers Association (MBA) reported that the Refinance Index fell 11.2% to 2043.4, while the Purchase Index was off 10% to 342.2.

The MBA's survey reported that the 30-year fixed contract rate rose back above 6% to 6.08%, surging 26 basis points from the previous week as MBS lagged on all the cataclysmic events. The one-year ARM contract rate rose seven basis points to 7.01%. As a percent of total applications, refinancing and ARM share were both unchanged at 51.6% and 4%, respectively.

Mortgage application activity is expected to move higher in the weeks ahead as GSE and Treasury buying of MBS is expected, which should lead to more attractive mortgage rates.

Performance Outlook

In terms of the outlook for mortgages, as this new financial world order got under way last week, JPMorgan Securities analysts favored an overweight to MBS versus Treasurys but cautioned to hedge mortgages very short, since the correlation of mortgages versus Treasurys has plummeted. Meanwhile, UBS analysts turned neutral from overweight as they see mortgages as rich to the average of five- and 10-year swaps. In addition, there are quarter-end balance sheet constraints, as well as investors moving down in credit in light of the Treasury plan, they said.

Street analysts are beginning to revise upward their outlook on prepayments in the near term given the sharp drop in mortgage rates and the increased percentage of the mortgage universe with a decent rate incentive. September prepayment speeds are projected to be lower by 4% in FNMAs and 1% in GNMAs, about 1% improved from our previous report. Contributing to the decline is lower refinancing activity in August, as well as higher mortgage rates.

The Refinance Index averaged 1052, down 18% from July's average. At the same time, the 30-year fixed mortgage rate averaged 6.48%, off five basis points from July's average. Day count holds steady in September at 21 days. The September prepayment reports will be out on Oct. 6, with paydowns estimated at $33 billion.

October speeds are expected to jump more than 60% in FNMAs from September's average, about twice as much as previously predicted. GNMA speeds are forecast to increase more than 30%. The largest percentage gains are in 2007 and 2006 vintages and in 6% and 6.5% coupons.

In part, premium coupon speeds are expected to be impacted by increased buyout activity from the GSEs, which has been on hold for some time due to their capital situation, as well as from delinquent refinancing through the Federal Housing Administration.

(c) 2008 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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