Prior to the Federal Reserve Board announcement last Wednesday, mortgages saw good buying support as supply had slowed down to less than $2 billion per day from the previous week's $4 billion per day level. The supply-induced spread widening attracted investors, as did the prospect of a Fed rate cut and the return of the CMO bid. Buying flows were concentrated from current coupons to premium coupons in both 30- and 15-year MBS. The higher coupons benefited as alternatives to more typical money market investments, as well as managers employing barbell strategies.

Dwarfs also saw good buying interest as that sector has lagged 30s. Bear Stearns believes investors should take advantage of the underperformance or Dwarfs relative to 30s. Once rates back up, Bear says, 15-year MBS tend to outperform as the demand for extension protection heats up. At the same time, an increase in rates will lead to lower supply in this sector.

Following the announcement, buying flows slowed down as supply picked back up to near the $4 billion level on the market's sell-off on disappointment that the Fed reduced rates just 25 basis points rather than 50 basis points. Thursday's early flows saw a continuation of sidelined investors as the market continued to sell-off.

Over the Wednesday-to-Wednesday period, spreads on 30-year Fannie Mae 5s had tightened 14 basis points; 5.5s 17 basis points; 6s 20 basis points; and 6.5s 12 basis points. In Dwarfs, 4.5s firmed eight basis points; 5s 10 basis points; and 5.5s and 6s eight and seven basis points, respectively.

The near-term outlook remains favorable for the mortgage sector. Monday brings month- end buying support. For June, Lehman Brothers reports the MBS Index is expected to extend 0.10 years. This is slightly less than the 0.12 average experienced for the first six months of the year. The U.S. Treasury Index will extend just 0.02 years, Agencies will lengthen 0.11 years, and the Credit Index will climb 0.07 years. Overall, the Aggregate Index will move out 0.09 years.

Other near-term events that tend to favor mortgage performance include the employment report (July 3) and the calendar flip (July 10 for 30-year conventionals). In addition, paydowns are expected to increase over the next three months as prepayments pick up. With rates expected to hold low for some period of time, the mortgage sector should benefit as it offers attractive yields, spreads and quality. At the same time, bank buying is predicted to pick up after a lull as the economy remains sluggish, keeping C&I lending light.

On the supply side, fixed-rate volume is expected to hold flat to negative. This is due, in part, to increased refinancings into 15-year mortgages and ARMs.

Mortgage applications decline

For the week ending June 24, the Mortgage Bankers Association (MBA) reported that both the Purchase and Refi Indexes declined. The Purchase Index fell 2% to 411, and the Refi Index dropped 10.5% to 8205. Countrywide Securities noted a slowdown in refi applications the prior week as the market sold off. As a percentage of total applications, refinancings were 75.8% versus 77.3% in the previous report. At the same time, the share of ARM activity increased to 15.6% from 14.4%.

In a report released shortly after the MBA's announcement, Citigroup commented that the dip in the Refinancing Index was primarily due to a backup in mortgage rates. The report said that the Base Mortgage Rate, based on secondary market prices, increased 16 basis points week-over-week. The no-point survey rate, based on primary market rates, also increased by nine basis points.

Citigroup noted that the values of the Index for the past three weeks have been below the levels suggested by previous experience. The report said that this might indicate burnout as well as changes in the composition of the mortgage universe.

Freddie Mac reported gains in fixed-rate mortgage rates for the week ending June 27; however, the increases were much less than expected. The 30-year fixed-rate mortgage rate rose three basis points to 5.24%; the 15-year fixed rate mortgage rate gained one basis point to 4.63%; and one-year ARM rates reported another decline to 3.45% from 3.51% last week. This sets another new record low for adjustable mortgage rates.

Meanwhile, Citigroup also noted that the government index has been growing faster, or rather declining more slowly than the conventional index, in four of the last five weeks. This might imply larger increases in Ginnie Mae speeds versus those of conventional collateral going forward, analysts say.

Prepayments peak in August

At this time, prepayments are expected to peak in the August report with speeds the following month declining slightly and then holding essentially flat. Fannie Mae 15s and 30-year Ginnies, in particular, are predicted to show similar to greater acceleration than Fannie 30s. JPMorgan Securities expects Golds to accelerate slightly more than Fannies. The accompanying table gives the current consensus prepayment outlook.

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