Since the February employment report, the yield on the 10-year has fallen 30 basis points. For the mortgage market, this has dramatically increased prepayment and convexity fears - and investors responded accordingly last week by moving down in coupon. Particularly hard hit were 30-year 6s. In addition, the decline in rates has led to increased selling from originators to a daily average of $2 billion last week, up from recent averages of $1 billion.

Over the past week, option adjusted spreads on 30-year Fannie Maes were unchanged in 4.5s; one basis point wider in 5s; and plus three and four basis points, respectively, for 5.5s and 6s. Meanwhile, 15s lagged 30s with spreads moving out six basis points in 4s; eight basis points in 4.5s; and nine basis points for 5s.

JPMorgan Securities said in last week's research that it is now neutral on the basis with refi risk increased dramatically. Analysts are "wary of the possibility for a mini rate whipsaw as refinancing supply rises." Lehman Brothers is holding with their core short in mortgages.

Analysts are unsure as to whether or not the recent growth in bank holdings is sustainable. In addition, they "do not share the market's seeming complacency about the aggregate convexity, especially on the call side."

Credit Suisse First Boston remains cautiously optimistic and favors 30-year 5s and 15-year 5s. CSFB said 30-year 5s offer attractive carry, while 15s offer cheap convexity and have lower risk of negative prepayment surprises. Meanwhile, UBS raised its recommendation to a slight overweight from neutral as a result of recent cheapening. According to the firm, 5s through 6s now appear to be marginally cheap based on regression analysis, and coupon relationships between higher and lower coupons are close to fair value. Finally, Countrywide Securities notes that while supply has not yet become an issue, "valuations are problematic for coupons that have, until recently, offered the advantage of strong carry."

Convexity risk

With the 10-year yield down to the low-to-mid 3.70s from the March 4 close of 4.01%, the rally has been fast and furious. Morgan Stanley calculated that Friday's employment report rally led to about $35 to $40 billion of 10-year buying/receiving needs due to convexity demand. Last Monday's rally added $11 to $14 billion, and Tuesday's rate decline added somewhat less. Morgan Stanley said that given the benign move in swaps spreads, MBS portfolios might still have hedging needs, which suggests further declines in rates. Add to that Japanese intervention, and rates are anticipated to hold lower.

In comments last week from Lehman regarding the convexity risk in the market, analysts asked, "Should we be worried about aggregate convexity risk in a further rally?" Given the composition of today's market versus last May, there is currently more call risk in the market. With 5s and 5.5s dominating the index, said Lehman, both of these securities can shorten considerably in a further rally. Lehman also noted that servicers still have some negative convexity, which suggests hedging flows from this group would not be negligible if rates continue to fall.

However, while aggregate convexity risk is worse now than it was last May, there are some offsets, Lehman said. First, servicers have a natural hedge from their origination business in a rally, and MBS investors can correct duration mismatch by reinvesting paydowns into current coupon MBS. Furthermore, origination pipelines were larger in May than they are today. "Consequently, a further rally from here does not look terrible from the standpoint of convexity hedging," said Lehman.

On the other hand, there is a significant buildup in extension risk at lower rates. Lehman calculates that if rates stay at current levels for a few weeks, the extension risk in pipelines would grow by $75 billion in 10-year equivalents. If the market rallies 50 basis points and stays there for a few weeks, the extension risk would increase by an additional $50 billion in 10s, analysts said.

UBS added that there must be a catalyst - such as the employment report - in order for convexity needs to be realized. Should the percentage of mortgage applications that close increase, the resultant market sell-off could also serve to further convexity needs, suggested UBS. At any rate, "the strengthened convexity bid will clearly result in greater fixed-income market volatility," concludes UBS.

Mortgage application activity little changed

Mortgage application activity was up just slightly for the week ending March 5, according to the Mortgage Bankers Association (MBA). The Purchase Index rose 1.5% to 429, while the Refi Index gained just 1% to 3567. As a percentage of total applications, refis were 56.1%, down slightly from 56.4% in the previous release. ARM share was also lower at 28.1% versus 28.8%.

The late week apparently didn't provide enough time for borrower response. Countrywide Securities reported a pickup in activity, particularly in refinancings. Based on its experience, the firm was predicting a read of between 3800 and 3900. This suggests that this week's report should see a sharp increase. In fact, looking ahead, Lehman said it expects the Refi Index to cross 4500 in the coming weeks.

As expected, mortgage rates fell dramatically as a result of this latest rally. For the week ending March 12, Freddie Mac reported that the 30-year fixed-rate mortgage rate is now at 5.41%, down 18 basis points from the previous report. Meanwhile, 15-year mortgage rates are at 4.69%, versus 4.88% previously; one-year ARM rates slipped six basis points to 3.41%. These levels are the lowest for this year, and the lowest since early July of last year. Mortgage rates hit their record lows in early/mid-June of last year. They were 5.21% on the 30-year, 4.60% on the 15-year and 3.45% on the one-year ARM.

Current levels now expose over 70% of the mortgage universe, or more than $2 trillion, to some refi incentive.

Conventional prepays surprise to upside; Ginnies in line

With the exception of 7s and 2003 vintage 5s, which prepaid in line with consensus, speeds on lower-coupon Fannies were mostly faster than expected. Bear Stearns attributes the strong results to several factors including excess capacity in the mortgage pipeline; a doubling of application volume from the start of the year; and attractive hybrid alternatives. Freddie Mac MBS continued to prepay slightly slower than similar Fannies for 6s and higher coupons. Lehman attributes this level to greater burnout from their faster speeds during the peak refinancing months of 2003.

According to JPMorgan, paydowns in the fixed-rate agency market totaled about $70 billion, an increase of 35% from January. As a result, the amount of outstanding agency paper shrunk by $10 billion.

Speeds on 30-year Ginnie Maes were in line with consensus expectations except for 6.5s, which were faster than predicted. Speeds on these securities, however, continue to be faster than similar Fannie Mae MBS. In previous comments from Bear Stearns, analysts noted that with the excess capacity mortgage bankers are experiencing now, they have refocused their efforts on this universe of borrowers. In addition, they believe prepayments have been inflated by servicer buyouts. Bear Stearns expects that this "current anomalous situation is a temporary phenomenon that will correct itself in a few months" as this universe of refinanceable loans shrinks. Further narrowing is expected to occur as mortgage bankers shift their attention back to conventionals with this latest rally.

Prepayment outlook

With the expected increase in application activity, the prepayment outlook is calling for strong gains through April for 6s and lower, while May is looking to be essentially flat from April. For example, 2003 Fannie Mae 5.5s are expected to prepay at 25% CPR in March; 31% in April; and 34% in May. Meanwhile, 2003 6s are seen at 38%, 43% and 44%, respectively.

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