Mortgage banker supply picked up last week, averaging $2 billion per day. Investor activity, meanwhile, was mixed with early week interest in the up in coupon despite the outlook for much higher prepayments in the coming months. In comments from Credit Suisse First Boston, analysts believe it is too early to "leg into 6s or 5.5s." They preferred moving into 5s, despite their recent strong performance, due to the attractive hedged-carry and minimal prepayment risk. Still, banks and money managers were better buyers of 5.5s and 6s.

This changed in mid-week as the convexity demand finally started to get more attention. Institutional demand was focused on 5s and lower to pick up duration and reduce prepayment risk. Over the week, spreads were three basis points tighter in Fannie Mae 30-year 4.5s and 6s on an OAS basis. Meanwhile, 5% coupons were two basis points wider, while 5.5s were one basis point firmer. In 15s, spreads were five to six basis points weaker in 4s through 5s. A good portion of last week's originator supply was in 15-year paper.

Lehman Brothers, which had been underweight mortgages for most of the year, turned neutral last week given recent mortgage underperformance. With the Fed not expected to move toward a tightening bias this year, bank demand should remain strong, Lehman said. Further, technicals are favorable given the convexity risk. According to CSFB, other favorable points for mortgages are: (1) OASs are at their 6-month wides; (2) paydowns in March and April are expected to be $90 billion and $110 billion, respectively, and are expected to be reinvested back into the mortgage sector; and (3) current OAS may entice the GSEs to become more active.

What's the convexity risk?

The latest rally has put convexity risk back on the radar screen. In a recent report, Linda Lowell, an analyst at RBS Greenwich Capital, discussed the risk to the market, particularly if rates sell off. She estimated current total hedging requirements for 30-year Fannies are around $216 billion. A 50 basis point selloff would increase this amount to $361 billion, while a 50 basis point rally would reduce the "theoretical hedge" to $161 billion. There is a concern that an abrupt backup would result in a situation similar to what occurred last July in the market. Lowell says that this time the makeup of the mortgage market is different, with 75% of the market concentrated in 5s through 6s versus 63% last July. Also in July, 6.5s made up 22% of the market versus 12% currently. She concluded that "higher concentrations of longer coupons should soften the impact of a sharp backup relative to what happened last summer."

Analysts recommend specified pools

Given the convexity risk in the market, analysts are generally recommending investors look at specified pools (see related story, p. 15). While specified pools command a pay-up, at this time they are currently cheap. According to UBS, rates are similar now to last July; however, specified pools are cheaper now versus that month. In addition, given the expected jump in prepayments over the next couple of months, the pay-up should be recovered in a short time - two or three months - as speeds on specifieds are traditionally slower. It also results in additional carry for the investor. Based on their analysis, UBS states that investors should not own 5.5% or 6% TBAs, but should be buying specified pools instead. In addition, investors who own fast pools should sell them and buy specifieds. For dollar rollers, UBS notes that rolls are not very special in 5.5s and 6s; therefore, for these investors, specified pools still make more sense.

Mortgage applications jump

The Mortgage Banker Association (MBA) reported that mortgage application activity jumped in response to the sharp drop in mortgage rates last week. "We have been expecting a sharp uptick in refinance applications as borrowers became more aware of the low rates now available, whether through ads by lenders, from direct solicitations or from stories in the news media," said Jay Brinkmann, vice president of research and economics at the MBA. "Keep in mind, however, that even with this surge in refinance applications, the share of applications for adjustable rate mortgages is staying the same at almost 28% of applications and over 42% of the dollar volume. This means that a sizable percentage of these refinance applications are for adjustable rate loans." Further, fixed-rate issuance may be even lower than expected. JPMorgan Securities says in such a case, supply-induced widening may not fully materialize as supply is likely to be below pent-up yield demand.

For the week ending March 12, the Purchase Index rose 5.6% to 452 and the Refi Index surged 40% to 4984. As a percentage of total applications, refinancings were 62.8% versus 56.1% in the previous report. ARM share fell to 27.9% from 28.1%. Looking ahead to next week's report, JPMorgan predicts the Refi Index will be in the mid-5000s.

30-year mortgage rates slip

Freddie Mac reported a slight decline in 30-year fixed-rate mortgage rates and in ARM rates for the week ending March 19. The 30-year fixed-rate mortgage rate fell

three basis points to 5.38%.

The one-year ARM rate was also down three basis points to 3.39%. Lastly, 15-year fixed-rate mortgage rates were unchanged at 4.69%.

Current rates are now only about 20 basis points away from their lows of last July. However, even if the market gets back to that point, overall prepayment volume would be 30% to 35% below peak levels seen last summer, according to Lehman. Also, expectations are that if mortgage rates drop 20 basis points, the Refi Index should

cap out at around 7000, and peak monthly 30-year paydowns should stay below $90 billion versus 128 billion in July 2003.

With the increase in application activity, prepayment rates are predicted to increase sharply in the next couple of months, particularly for 6% and lower coupons. The table on this page gives the latest consensus reading on prepayments.

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