The Treasury's unexpected elimination of its 30-year bond auction sent a shockwave through the mortgage-backed market last week, spiking volatility in the sector to its historical high, reconfiguring the yield curve, and throwing the 30-year mortgage rate to its second-lowest level ever - on its way to an all-time record low.

The Mother of All Refi Waves' is approaching, sources predict.

"Mortgage [spreads] got very, very tight, the Treasury market flattened, volatility hit its highest level on Thursday, and every coupon is getting squeezed," said David Montano, the head of mortgage research at Credit Suisse First Boston. "The yield curve impact was wild."

"We are now looking at the lowest rates in the 31-year history of the mortgage market," said another MBS veteran.

Since Friday, Oct. 26, the 10-year Treasury yield was down 42 basis points, to 4.10% as of Thursday, Nov. 1. The yield is lower than levels seen in Oct. 1998 and prior to that in the mid-1960s.

Before the news of last week, mortgage originators already were running at full capacity, sources said. As a result, they are less inclined to lower rates until demand at the higher levels has been exhausted.

It is, however, starting to show up. For the week ending Nov. 2, Freddie Mac announced that fixed mortgage rates had dropped after increasing over the previous two weeks. The 30-year fixed mortgage rate declined eight basis points to 6.56% and the 15-year fixed mortgage rate nine basis points to 6.04%. The 30-year rate is nearing the record low of 6.49% set in Oct. 1998.

Last week's survey, however, does not capture the 40-basis-point plunge in yields. As a result, this week should see a further drop in mortgage rates, perhaps setting a new record.

In comments on Thursday, Lehman noted that 30-year mortgage rates (with points) fell to 6.18% and are now about 100 basis points lower than rates seen over the last nine months. In addition, they are around 60 basis points below levels that spurred the 1998 refi wave.

However, the Mortgage Bankers Association announced that its Refi Index fell 8% to 4203.5 for the week ending Oct. 26. As a percent of total applications, refinancings fell to 73.9% from 75.5%. It was somewhat of a surprise, as rates had started to come down after increasing; however, with last week's dramatic plunge, the index should start trending higher once again.

"When you are above 4000 on the Refi Index, there is not a lot of room to go up," said an MBS analyst. "At these levels, you are near the maximum capacity that the origination system could handle. We have now hit four straight weeks above 4200; this is opposed to before Oct. 2001, when there was only one week in the history of the Index that it reached 4000."

Rates are nearing levels that could bring some portion of 6% coupons for its first-ever refi opportunity. With the inclusion of this, Bear Stearns calculates that 92% of the fixed-rate mortgage universe is exposed to refi risk. This translates into monthly supply of between $142 billion and $160 billion.

Investors panic

For the past several weeks, the story in mortgages has been about increasing supply, but the supply had been easily absorbed by strong buying from banks, money managers, arb accounts, and dealer desks.

But this was not the case last week in mortgageland. Rather, the story was about the Treasury's elimination of its 30-year auction. This sent longer-term yields plunging and mortgage players scrambling to add duration through options and 10-year Agencies.

The mortgage market is at a rather precarious stage at the moment, analysts say, as the average price is over 103. Conventional 6% coupons, for instance, are around 101 to 116, leaving only the small 5.5% coupon at par.

With last week's volatility, mortgage activity, while two-way, was relatively modest. Originator supply averaged about $1 billion or less per day. Banks and arb accounts were only light buyers while money managers took profits.

Additionally, concern is arising with the flattening curve and low rates regarding CMO creation, said mortgage researchers. CMOs have been a heavy source of demand for the mortgage supply over the past several months.

The capacity issue

Even before last week's rally the expected mortgage refinancing volume was expected to be the largest ever; however, this was further compounded by the rally, as one might expect.

Analysts mention that the question is not so much what the homeowners' response would be - it is obvious that with mortgage rates at their all-time lows, homeowners are going to rush to refinance - but how much mortgage bankers are actually capable of refinancing in a given month, or how many they can realistically close.

"I think we are definitely hitting up against mortgage banker capacity constraints," said Glenn Boyd, an associate director at UBS Warburg. "That is going to be the limiting effect in terms of what the absolute level of speeds we could see each month going forward."

According to Boyd, the recent rally is going to push the refinancing wave to extend longer in time because the refi pipelines are basically swelled to bursting. There is no way originators are going to accommodate the entire pipeline in one month, analysts say, and there is going to be signigicant spillover into the subsequent months.

Furthermore, there will be longer lags in prepayments for seasoned collateral, since mortgage bankers will not be able to process all the loans that are coming in. The degree to which this is true depends, of course, on how efficient mortgage bankers are at queueing up their loans so that streamlined refis get processed first and standard refis go through second.

This would also imply that seasoned vintages would still prepay at very fast speeds but not in the next one or two months. Instead, there would be faster speeds on new production in the next couple of months because of streamlined refis.

In a recent report, Bear Stearns, for instance, said that the average lender "is originating loans with slightly higher margins to control the refinancing spigot."

Bear said that this means that they would be doing the easy, streamlined refinancings first, while seasoned borrowers that would require full underwriting will have to wait.

Analysts from the bank said that this does not mean that the seasoned transactions will not get done, but it only means that they will be delayed. Because of this, Bear has increased the lag on all of its seasoned (pre-1999) projections.

One thing seems to be certain: with the onslaught of new refinancings, bankers are likely to become more efficient than they were previously.

Impact on prepayments?

This week, the Street should start making upward revisions to their prepayment forecasts based on the latest level in rates. It shouldn't be surprising to see peaks that were previously expected to hit in Dec. and Jan., depending on coupon and vintage, to be pushed out to possibly Jan./Feb.

In addition, declines following peaks are expected to be small. At this time, the Street has speeds slowing only 1-4% CPR. To estimate the potential for speeds, Lehman calculated the following (see table) one-year prepayment rates for conventional 30-year collateral assuming a Refi Index in excess of 6500.

On Wednesday, Nov. 7, the housing agencies will release speeds covering the month of Oct. As highlighted last week, there is some difference on the Street regarding Ginnie Mae speeds.

The MBA's Gov't Index lagged the gains recorded in the Conventional Index. As a result, some expect speeds to show more moderate increases with similar gains following in Nov. Others, however, are predicting a jump in speeds in October and only modest gains of around 5% for most coupons and vintages in the Nov. report.

Conventional 30-year MBS are expected to increase about 40-70% for most coupons and vintages in Oct., and gains of 20% and less for Nov. at this time. Specifically, 2001 6.5s are predicted to increase to around 14% CPR from 5% in September; 2001 7s to 37% CPR from 15% CPR; and 2000 7.5s to 59% CPR from 45% CPR.

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