Mortgage activity last week was uneventful and uninspiring. Originator selling averaged about $1 billion per day and was mostly in 5.5% coupons. Investor activity was mixed with profit taking by money managers and banks in higher coupons moving down in coupon into 5s. This situation was masked by higher coupon buying from servicers and foreign investors into 5.5s and 6s.

Month-end index buying was anticipated for Friday's session. According to Lehman Brothers, the MBS Index is forecast to lengthen 0.09 years, the same as January. In other sectors, Lehman calculates that the Treasury Index will lengthen 0.8 years due to the Treasury Refunding; the Agency Index is set to add 0.06 years; and the Credit Index should increase 0.06 years. Overall, Lehman estimates the Aggregate Index will extend 0.08 years.

Over the week, spreads widened two basis points for 30-year Fannie Mae 5% coupons through 6% coupons. Meanwhile, 6.5s moved out seven basis points. In dwarfs, spreads were one to two basis points weaker in 4.5s and 5s, and unchanged in 5.5s.

Street analysts are mixed on the mortgage sector. Last week, JPMorgan Securities upgraded its recommendation to maximum overweight due to the recent slight market backup and the decline in volatility. The firm also noted that mortgage OAS are near their widest levels in four months. Another potential positive is that the GSEs are not going to be able to sustain their recent portfolio shrinkage and will be back. In addition, mortgage holdings at banks are approaching their June highs. Analysts see further MBS portfolio growth on a combination of continued poor C&I lending and declining income from mortgage originations.

Lehman is holding with its mortgage underweight but as implied volatility grinds lower, analysts are getting nervous around their hedges on mortgages. The roll market is threatening to come back to life due to mega creation recently, researchers also noted. February was the biggest month in mega pool creation. According to JPMorgan, in February there were $40 billion megas created off of FNMA 5s; $12.5 billion off FNMA 6s; and $10 billion off FNMA 5.5s.

UBS said it was holding with its neutral recommendation on the mortgage basis, noting that while the sector remains rich, technicals are excellent. Countrywide Securities is positive on the sector, saying that as long as the range in interest rates hold, demand is likely to remain strong leading to tighter spreads.

So what is the current risk in the mortgage market?

At this time, the main short-term risk to the mortgage market is refinancing-driven supply, said JPMorgan analysts. They say 3.75% on the 10-year Treasury is the trigger that would make them more cautious on the mortgage basis. Credit Suisse First Boston says that while the aggregate market exposure to refinancing incentives is relatively low at 46.4%, "a significant balance of outstanding MBS are at risk of rallying rates." They calculate $553 billion of MBS have a 50 basis point or less incentive. This compares to $279 billion in early December. If mortgage rates drop another 30 basis points, the portion of the MBS market that becomes exposed to a 50 basis point incentive jumps to 74.3% due to the inclusion of the large 5.5% coupon.

Mortgage application

activity rises

According to the Mortgage Bankers Association (MBA), mortgage application activity recorded a slight increase on a seasonally adjusted basis for the week ending Feb. 20. Both the Purchase and Refi Indexes rose 2% to 424 and 3362, respectively. The data was adjusted by a half-day for the Presidents' Day holiday. If a one-day adjustment had been used, the Refi Index would have risen 15% to 3782, says Citigroup Global Markets. On an unadjusted basis, the Purchase Index fell 5% to 414 and the Refi Index declined 8% to 3026. As a percentage of total applications, refinancings were 55.7% versus 56.6% in the previous report. The ARM share was unchanged at 27.1%.

According to Freddie Mac's Primary Mortgage Market Survey, 30-year fixed-rate mortgage rates held unchanged at 5.58% for the week ending Feb. 27. This is a bit of a surprise as analysts were expecting the rate to increase to 5.62% to 5.65%. The current level keeps rates at their lowest level for the year, and the lowest since mid-July.

Freddie also reported that 15-year fixed-rate mortgage rates rose two basis points to 4.89%, while the one-year ARM rate fell three basis points to 3.50%. Looking ahead to this week's mortgage application report, Lehman expects the Refi Index to remain above 3000 with rates holding at current levels. JPMorgan anticipates the Refi Index to hold steady at 3300.

Will February surprise?

On March 5, the housing agencies release prepayment reports for the month of February. Consensus anticipates speed increases of 35% to 40% for 30-year conventional 5.5s and 5s; 20% to 25% for 2002 and 2003 6s; and around 10% for higher coupons. JPMorgan warns of another potential downside surprise. In conversations they have had with mortgage originators, some originators have suggested they expect to be up 20%, while others expect to be unchanged to down. A surprise to the downside would be positive for higher coupons. They benefited from such a surprise earlier this month following release of the January report.

Countrywide considers Refi Index level on premium speeds

The current level of higher than 3000 on the Refi Index doesn't seem all that fearsome given the levels reached last spring. Still, the current level of the Refi Index represents an increase in volume of nearly 50% over the average seen from late August to early January, says Countrywide. What this suggests is that fast speeds on premiums can be achieved at much lower levels of the Refi Index than were experienced in 2002 and 2003.

In a recent analysis of the relationship between the Refi Index and prepayment volume, Countrywide concludes there are two important points for investors to consider. For one, the relationship between the two is linear with an R-squared of 92.8%; secondly, a Refi Index in the range of 3000 to 3300 is consistent with about $60 billion per month in prepayments on fixed- rate Fannie and Freddie 30- and 15-year MBS.

The Refi Index has a diminished responsiveness now due to low current balances on higher coupons, observes Countrywide. For example, Countrywide notes, the total amount of conventional high coupons have fallen by half since late 2002. If prepayment speeds in February 2004 were identical to those in the fourth quarter of 2002, the dollar volume of prepayments, and, therefore, the level of the Refi Index, should be just half the level seen then. In other words, a 3000 level on the Refi Index could generate the same CPRs that 6000 on the Refi Index did in late 2002.

Countrywide's analysis goes on to address the question: What does a Refi Index of 3000 mean in terms of actual CPRs today? Using the estimate of $60 billion in monthly paydowns, Countrywide estimates speeds of 47% CPR on 2001 to 2002 origination 30-year 6s, and 26% CPR on 2002 origination 5.5s. Consensus currently predicts 2002 to 2001 6s to reach 37% to 38% CPR in March, before declining in April. Meanwhile, 2002 5.5s are expected to reach 23% CPR.

Countrywide says its analysis is not a projection per se and does not come from any formal prepayment model. Rather, it generates prepayment volume consistent with the current level of the Refi Index. Still, it illustrates the risk that is still in the market, and the firm says it believes "investors should not be lulled by the relatively slow speeds of the last few months or by what seems to be a quiet' Refi Index."

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