Mortgages experienced modest two-way flows last week as the 10-year Treasury yield hovered around 4%. Servicers were good buyers in the lower coupons, while hedge funds and money managers were active both up and down the coupon stack seeking carry and convexity. Originators, meanwhile, remained at $1 billion per day on average. Mortgage participants were noticeably inactive in the Treasury or swaps market. It is generally expected that it would take a move to 3.9% and below to really stimulate activity in those markets. Over the week, spreads were tighter by two to three basis points in 30-year Fannie Mae 4.5s through 6.5s, and one basis point better in Dwarf 4.5s through 5.5s.

Most firms are neutral on mortgages given the current yield levels. In recent comments from Deutsche Bank Securities, for instance, analysts noted that while 4% on the 10-year is not seen as a major prepayment threshold, it is still seen as a significant event by many MBS participants. In addition, Deutsche added that these yield levels are not conducive to bank support unless interest rates stabilize. The looming presidential election and October nonfarm payrolls also suggest the risk of higher volatility in the near term.

Countrywide Securities added that the MBS market remains highly rate-directional and they advised caution on the basis as they see the risk/reward trade-off tenuous at current levels. Bear Stearns also likes the neutral stance due to the tight option-adjusted spreads.

Analysts express concerns regarding the prospect of bank support due to the uncertainty of EITF 03-1, and GSE support as a result of Fannie Mae's accounting issues. At the same time, outstanding fixed rate supply continues to decline. Given the technicals, Bear Stearns believes the only thing that will really push spreads wider is a new refinancing event, and that is not expected unless the 10-year falls to around 3.75%. UBS and JPMorgan Securities, on the other hand, continue to recommend a modest overweight to mortgages due in large part to the limited supply.

Mortgage application activity increases

The Mortgage Bankers Association reported that mortgage application activity rose for the week ending Oct. 15, as mortgage rates slipped. The Purchase Index was up around 6% to 461 on a seasonally adjusted basis, while the Refinancing Index was up nearly 11% to 2155. The data was adjusted by a half day for the Columbus Day holiday despite the fact that most mortgage lenders were open. On an unadjusted basis, purchases were down 5% to 398, while the Refinancing Index was little changed at 1940 versus 1949 the prior week. As a percentage of total application activity, refinancings were 45.6% versus 44.5% in the previous report. ARM share was essentially unchanged at 34.8% versus 34.9%.

For the week ending Oct. 22, fixed mortgage rates dipped in response to further declines in interest rates. The 30-year fixed rate mortgage rate declined to 5.69% from 5.74%, and the 15-year rate was down seven basis points to 5.07%, according to Freddie Mac's weekly mortgage rate survey This is the lowest level in six months said Freddie Mac. Meanwhile, the one-year ARM reported in at 4.02% versus 4.01% last week.

Given current mortgage rates, expectations are for the Refinancing Index to hold around its current 2200 area in this week's MBA mortgage application activity report. It is expected that it will take a drop of around another 15 basis points in the 30-year mortgage rate to cause a significant response in the index.

Prepayment outlook

Given the modest response of the Refinancing Index in recent weeks, speeds on seasoned and higher coupons are expected to increase just modestly in the October report. UBS points to the lower rate attractiveness, media response and burnout - as borrowers already had numerous opportunities to refinance - as the reasons for the limited gains in premium coupon speeds.

Analysts also report refinancings into hybrids have been declining and is being replaced by other shorter-reset ARMs such as negative-amortization Libor, MTA products and six-month Libor ARMs. Of the 32% of refinancings into ARMs last spring, 29% were to hybrids. In September, 24% of the 42% ARM share was into hybrids.

Looking ahead to the October report, speeds on 30-year FNMAs are expected to increase 5% to 10% for most coupons and vintages with the exception of 5.5s, which are predicted to increase around 20%. The November forecast has speeds essentially unchanged from October's levels. The trend is similar in 30-year GNMAs, though 5.5s are estimated to increase slightly less at 10% to 15% in October.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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