Extension risk was the watchword as the week started. Early week research from both Countrywide Securities and Barclays Capital, for example, highlighted the risk, saying that the mortgage market hadn't yet begun to reflect the significant extension risk. The analysts added too that the increase in interest rates could put further pressure on the housing sector as well as slow down prepayment speeds. Barclays noted that accounts were slowing their prepay models and lengthening durations to account for the effect of weak housing. This could lead to portfolios shedding duration, they said. They added that investors that were long duration in anticipation that the Federal Reserve would be cutting rates could be shifting their views in light of the recent data, and so start selling MBS.

The selling arrived on Thursday. When New York opened, the 10-year yield was above 5%, and prices steadily gave ground throughout the morning. The increase in yields was attributed to news of a surprise rate hike overnight in New Zealand and talk that Australia may be next. The steady rise in domestic interest rates recently has been due in part to higher global rates. Stocks had been steadily setting record highs despite the higher interest rates, but that was arrested last week, as well, when the Dow started heading lower on concerns about higher rates.

By midday Thursday, the 10-year Treasury was down nearly a point with the yield at 5.10%. The selloff was further instigated by duration shedding by certain mortgage investors. Sources estimated originator selling at $3 billion, with an additional $6 billion in extension-related selling. In addition to the higher-rate impact on extension, the latest prepayment reports were also discouraging and will likely encourage the Street to adjust their prepayment expectations. Speeds were anticipated to increase about 7% to 10% on average due to a higher day count and stronger seasonals; however, FNMA speeds gained 2% to 4% on average. FHLMC Gold and GNMA reports recorded similar results.

The slowing housing market, tighter lending standards, higher guarantee fees and reduced cashout refinancings effected speeds, and these effects are expected to increase in the near term.

Mortgage Application Activity Mixed

Even ahead of Thursday's sharp selloff, mortgage volume was running above average last week as yield levels hovered in the mid-4.90s on the 10-year, and as the yield curve shifted from inverted to steeper again. Flows were mixed with pushes toward 5% leading to better selling and any strengthening leading to buying interest.

Participants were mainly domestic investors, although the participation was widespread. Despite the higher yield levels, Asian investors remained a limited participant. While Thursday was dominated by selling, there was some real and fast money starting to emerge - albeit limited - on the substantial cheapening. Spreads at midday were out four to five basis points in the belly of the stack versus the curve.

The Mortgage Bankers Association reported an increase in purchase activity and a decline in refinancings for the week ending June 1. The Purchase Index rose 1.5% to 433.6. Meanwhile, the Refinance Index was down 6.3% to 1757.7 in response to the jump in mortgage rates. This is the lowest the Refinance Index has been since the end of last year, when it reported in at 1640. The data were adjusted for the Memorial Day holiday. Previously, the MBA has used a half-day adjustment.

For the month of May, the Refinance Index averaged 2003, down just 1% from April's average. The Purchase Index, however, averaged 434 in May, up 5% from the previous month. During this period, 30-year fixed mortgage rates averaged 6.26%, eight basis points higher than in April.

As a percent of total applications, the refinance share fell to 38% from 39.7%. ARM share was essentially unchanged at 17.8%, versus 17.7% previously.

30-year mortgage rates gain

Freddie Mac reported that mortgage rates jumped again last week as interest rates continued their steady rise higher. Freddie Mac's Chief Economist Frank Nothaft attributed the rise "to market concerns of a tight labor force and wage growth. May's unemployment rate remained at the second-lowest level since May 2001, while average hourly earnings rose." In addition, he pointed out that the increase in unit labor costs is fueling inflation fears.

According to the GSE's weekly survey, the 30-year fixed mortgage rate rose to 6.53%, up 11 basis points from last week. Since mid-May, 30-year rates have surged 38 basis points and are nearing levels seen a year ago: 6.62%. Fifteen-year fixed mortgage rates were also up a sharp 10 basis points, to 6.22%, and are on top of levels for this time last year, 6.23%.

On the adjustable side, five-year hybrid ARM rates averaged 6.24% compared with 6.19% last week. One-year ARM rates are at 5.65%, eight basis points higher than previously. Current rates are two to four basis points higher than a year ago.

With further gains in mortgage rates, mortgage application activity is likely to stall or slip further.

(c) 2007 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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