Mortgages awoke from their long winter's nap and took off as investors embraced attractive carry, declining prepayment speeds, less supply and an expected range-bound rate environment. The strong demand more than offset the greater-than-expected originator volume that came last week, averaging roughly $1.5 billion per day.

Spreads tightened three basis points on 30-year Fannie Mae 5% through 6% coupons and six basis points for 6.5% coupons. Dwarfs, on the other hand, widened one to two basis points for 4.5s through 5.5s, and six basis points for 6s. Countrywide Securities attributed the weakness in 15s to curve flattening and weakening rolls. The firm also views 15-year pricing relative to 30s as too strong given the slope in the yield curve between five- and 10-years.

Mortgage application activity increases

The Mortgage Bankers Association (MBA) reported an increase in mortgage applications for the week ending Jan. 2. The seasonally adjusted Purchase Index rose 3% to 401 while the Refinancing Index gained 7% to 1755. On an unadjusted basis, the Purchase and Refi Indexes jumped 23% and 25%, respectively, to 214 and 1229. As a percentage of total applications, refis were 49.7% versus 49.3% in the previous report. ARM share, meanwhile, was essentially unchanged at 30.3% versus 30.4%.

Freddie Mac reported just a slight increase in mortgage rates for the week ending Jan. 9. Both the 30- and 15-year fixed-rate mortgage rates rose two basis points to 5.87% and 5.17%, respectively, while the one-year ARM rate increased to 3.76% from 3.72%.

With rates holding below 6%, application activity should start to pick up and move back above the 2000 level. This is most likely a couple of weeks away, however. JPMorgan Securities expects the week's Refi report to hold below 2000.

No surprise in Fannie prepays, but not so with Ginnie

Speeds on 30-year Fannies were mixed though they held fairly close to November's report, which was what consensus was calling for. The modest exception was 2002 5.5s, which increased 13% to 17% versus expectations of holding at 15% CPR.

In comments from Bear Stearns, analysts noted that speeds remain slightly higher than expected due to the fundamental factors of housing market strength, high levels of refinanced loans in pools, GWAC dispersion in cuspy pools and hybrid ARMs. Regarding the GWAC dispersion, Bear says that it appears that the two brief encounters with a 5.80% conventional rate, which occurred in early October and again in mid-November, seemed to have presented enough of an incentive to make higher GWAC borrowers refinance into another 30-year loan. They also believe the hybrid option is impacting 5.5% coupons.

Looking ahead, Bear believes that as long as rates remain range-bound and volume far short of originator capacity, fundamental factors will continue to have an effect on speeds, especially on the cusps. FTN Financial Capital Markets Senior Vice President Walt Schmidt adds that if rates hold near current levels, discounts should speed up going into spring on further ramping and seasonal effects.

December Ginnie Mae speeds came in faster than expected. In addition, speeds gained versus consensus expectations of declines of 5% to 10%. In comments from Citigroup Global Markets, analysts observed that no particular lender appeared to be responsible for the increase. Most likely, with the slowing in refinancings, lenders were able to focus on the FHA/VA portion of the market. UBS, meanwhile, expects Ginnies to underperform due in part to higher prepayment speeds and expanding market share. Analysts state that, with excess capacity among mortgage bankers, speeds on refinanceable GNMAs should converge with their conventional counterparts.

At the moment, consensus is anticipating January speeds to slow 5% to 10% due to the decline in the Refi Index as the holidays took over. The daycount will also be lower by two days.

According to JPMorgan, total fixed-rate agency paydowns totaled $61 billion in December. Analysts said the amount of outstanding fixed-rate agency MBS grew by $19 billion. Finally, the firm expects net issuance to continue to decline in the next few months.

S&P's outlook on CMBS and RMBS

Domestic issuance of CMBS is expected to be flat or decline in 2004 from 2003's level of $75 billion, said Standard & Poor's in a recent press release. The forecast is based on expectations of higher interest rates this year, though most of that is expected to occur during the second half.

S&P also noted that while volume should remain robust, stressed real estate fundamentals have been slow to rebound despite the strengthening economy. Depressed fundamentals in 2003 resulted in a record number of CMBS downgrades and defaults at 215 and 29, respectively. S&P attributed this to the lack of job creation in this recovery, stating that a weak job market reduces the demand for offices, apartments, industrial spaces, lodging facilities and retail sales. At the same time, however, upgrades outpaced downgrades at 301. "[We do not] expect 2004 to be as active as 2003 in terms of ratings actions," the rating agency said. "But we will most likely continue to see the number of delinquencies grow through the middle of 2004." Delinquencies are anticipated to level off in the second half of the year.

In the RMBS sector, S&P believes issuance volume will fall 30% to $400 billion from last year's $575 billion record. Like the CMBS sector, the decrease is due to the increase in mortgage rates expected this year.

S&P's chief economist, David Wyss, expects housing starts to be strong as mortgage rates hold relatively low. In addition, S&P believes that home price appreciation will continue, though at a slower pace, as the fundamentals of baby boomers buying second homes, immigrants buying first homes, historically low mortgage rates and house price affordability remain as factors.

Ratings upgrades in 2003 set a record at 1,192, while downgrades were light at 61 performance-related and 35 corporate rating dependent. S&P said the robust ratings actions were due to record fast prepayments, seasoning of underlying mortgage loans, shifting interest features of the transactions, market value appreciation, moderate delinquencies and low losses. Looking ahead to 2004, they anticipate the solid performance in ratings to continue as mortgage rates remain low and prepayments slow down.

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