Despite Friday's looming payrolls report, money managers, banks, insurance companies, dealers, and others were active buyers of mortgages. This was due in part to the recent cheapening, the beginning of a new quarter, and substantial cash positions. Technicals are also playing a part in the favorable performance. Originator supply remains modest at about $1 billion per day on average.

Historical performance is also supportive of mortgages going into payrolls. RBS Greenwich Capital Managing Director Alec Crawford said vols typically drop after the number is released, and so mortgages tend to do well on payroll Fridays. Over the near term, any pullback in the market should lead to increased demand as there is still plenty of cash sitting on the sidelines. The long-term outlook is less certain given Fannie Mae's accounting woes and EITF 03-1. However, technicals may continue to benefit the sector. JPMorgan Securities expects marginal net growth in the fixed-rate market. In fact, researchers anticipate 2004 net fixed-rate issuance to be the lowest ever.

In comments from Bear Stearns regarding the Fannie Mae issue, analysts say the key thing to watch is capital because it can potentially change the GSE's impact on the markets. The likely effect of developments regarding the agency MBS market is a neutral to negative impact for ARMs and 30-year MBS. As far as agency debt, there should be a positive impact for spreads in the long run; and for swaps and volatility, researchers expect a drop in volatility in both markets. Bear Stearns warns of an indication of mismanagement at the firm becoming a wild card, undermining confidence regarding "safety and soundness."

Refi Index increases slightly, said MBA

Mortgage application activity was mixed for the week ending Oct. 1. The Purchase Index slipped 2% to 459, while the Refi Index rose nearly 3% to 2271, according to the Mortgage Bankers Association. As a percentage of total application activity, refis were 47.1% versus 45.9%. ARM share was also higher at 33.9% versus 32.5% previously.

Bear Stearns analysts estimate the Refinancing Index is about 300 points below what is expected given the refinancing exposure in the market, suggesting two reasons for this. The first is the flattening of the curve has reduced the fixed-to-ARM and ARM-to-ARM refinancing incentive. The second is the recent lows in rates have not held long enough to generate a response. A significant response is not expected unless the 10-year moves towards 3.75%.

It was surprising that mortgage rates were higher given the latest selloff. Freddie Mac reported that 30-year fixed-rate mortgage rates rose 10 basis points to 5.82% for the week ending Oct. 8. Meanwhile, 15-year fixed rates reported in at 5.24% versus 5.12% the previous week, and the one-year ARM rate increased to 4.08% from 3.97%. Looking ahead to this week's mortgage application activity report, the Refi Index is expected to fall back towards 2000 from 2271 as a result of the increase in mortgage rates.

September prepayment speeds slower than expected

September prepayments came in slower than expected for both 30-year Fannie Mae and Ginnie Mae MBS. Regarding FNMAs, consensus expectations were for moderate increases in 6.5s and 7s. However, speeds declined in Thursday's report. Meanwhile, 5.5s and 6s were predicted to rise 15% to 20%, but came in less than 10%. The only exceptions were 2003 5s and 2003 6s, which came in on target.

Ginnie Mae speeds were also not as fast as consensus estimates. In fact, speeds for most cohorts were actually slower than in August, even 5.5s. Speeds, however, continue to be faster for Ginnies versus conventionals. Reasons for this include high delinquencies and servicer buyouts as well as refinancings into the more favorable conventional loan.

JPMorgan believes the Street would err on the fast side, despite the increase in the Refi Index this summer. Analysts suggested speeds wouldn't increase as much as expected due to one less collection day in September, weaker

seasonal turnover, and burnout on seasoned premiums.

Looking ahead to next month, speeds are expected to increase modestly given the lower mortgage rates; however, there is one less collection day and seasonal turnover should be similar to last month.

More than the most recent prepayment report, investors last Thursday said that market participants would primarily focus on the employment report that came out Friday. Depending on the outcome, this might take rates to lower levels and change future prepayment expectations. But based on current rates, Thursday's prepayment report should reflect the market's "current run rate, " said one investor. He said speeds probably "won't slow down or speed up much from this report."

The investor added that despite slower speeds on premiums, investors would probably stick to the down-in-coupon trade until there is more confirmation on the direction of the economy. Despite the Fed being on a tightening bias, there are still quasi-weak numbers that seem to indicate the possibility for economic weakness. At this point, the investor prefers to say in 5.5s and 6s as they offer superior carry to lower coupons. Last week's prepay report confirmed the attractive carry in these coupons, but a weak employment report would probably cause investors to favor lower coupons for prepayment shelter.

UBS tackles delinquencies and GNMA speeds

Higher delinquencies and the lower credit quality of the underlying borrowers have been some of the reasons given for the faster speeds on Ginnies versus conventional MBS. The other major reason, of course, has been the low mortgage rates that have encouraged FHA borrowers to refinance into conventional loans. So what happens when the market backs up? Will high delinquencies leading to servicer buyouts keep speeds on discount Ginnies faster than conventionals?

UBS addressed this issue in last week's Mortgage Strategist. Analysts said a geographic analysis points to home price appreciation as the driving force behind the fast speeds on Ginnie discounts. For states that have high delinquency rates, speeds have been consistently slower. This suggests that if mortgage rates rise enough, the saving of 60 to 70 basis points in mortgage insurance may not be enough for GNMA 5s or 5.5s to refinance. In this scenario, speeds would fall unless there is some offset from defaults.

In their analysis, UBS calculates that compared to Fannies, "delinquencies should boost discount speeds by only about 0.70% CPR for 1-year seasoned GNMAs, and by about 1.8 CPR on pools with WALA [greater than] 30." The firm's analysis analyzed historical discount speeds and MBA delinquencies. From this information, they derived a delinquency seasoning curve to quantify the impact of delinquencies on speeds.

"In a major sell-off, GNMA discount speeds are not likely to remain faster than FNMAs," analysts wrote. "Indeed, if home price appreciation cools (as is likely, in a sell-off), the greater sensitivity of GNMA speeds to equity growth is likely to overwhelm the modest boost from delinquencies - resulting in slower GNMA speeds while on the turnover seasoning ramp."

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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