The mortgage market enjoyed active two-way flows last week. It was a quiet start ahead of appearances on Tuesday and Wednesday by Federal Reserve Chairman Alan Greenspan. In his testimony on Tuesday before the Senate Banking Committee regarding the banking industry, Greenspan spooked the market by commenting that the banking industry was prepared for higher interest rates. The market sold off in response to this late Tuesday.

Then, late morning Wednesday, the market started to rebound when Chairman Greenspan spoke before the Joint Economic Committee on the state of the economy, saying "as yet, the protracted period of monetary accommodation has not fostered an environment in which broad-based inflation pressures appear to be building." The more positive tone encouraged investors to take advantage of recent widening, particularly in the lower coupons.

Over the Thursday-to-Wednesday period, spreads on an option-adjusted basis were unchanged in 30-year Fannie 4.5s, 5s and 6s, and one basis point wider in 5.5s where most of the originator supply has been focused. In 15s, spreads moved one basis point tighter in 4s and 4.5s, and two basis points better in 5s and 5.5s.

Improving economy raises questions

A big question in the mortgage market has been whether banks will continue to support the sector in light of an improving economy. Lehman Brothers expects banks will pull back from the MBS market when the Fed begins its tightening cycle, which is now looking to begin in the third quarter. From a historic viewpoint, they note that bank holdings have shown very little growth when the Fed has had a tightening bias. So far this year, banks have been strong buyers - around $100 billion year-to-date, according to Lehman - but this pace can't last indefinitely. A second point that keeps Lehman cautious is whether the buying is pent-up demand to reinvest paydowns, or a trend toward increasing mortgage holdings.

JPMorgan Securities estimates that banks currently have around $23 billion in unrealized gains including derivative hedges, and $12 billion excluding the derivatives position. Given the gains along with the percentage of assets in securities, JPMorgan expects banks to take some profits late in the second quarter. If C&I lending remains sluggish, it anticipates banks to put most of the money back into the MBS market.

Mortgage application activity mixed

For the week ending April 16, the Mortgage Bankers Association (MBA) reported a 0.4% increase in its Purchase Index to 434 and an 11% decline in the Refi Index to 2550. Activity was in line with analysts' expectations. As a percentage of total applications, refinancings were 47.3% versus 50.4% previously. ARM share rose to 31.7% from 29.4%. With rates continuing to rise, JPMorgan expects that next week's Refi Index could fall below 2000.

Mortgage rates rose less than expected for the week ending April 23. According to Freddie Mac's survey, the 30-year fixed-rate mortgage rate rose just five basis points from the prior week's level to 5.94%. Countrywide Securities Corp. was anticipating a print closer to 6.0%. Still, the rate is up 56 basis points from this year's 5.38% low on March 18.

Freddie Mac also reported that the 15-year fixed-rate mortgage rate gained only two basis points to 5.25%, while the one-year ARM rate was unchanged at 3.69%. With further gains in rates, analysts expect the Refi Index to fall to the low 2000s or high 1000s in this week's report.

Prepayment outlook

At this time, strong increases in speeds are anticipated in April for Fannie 5s and 5.5s, with more moderate gains predicted in higher coupons. Consensus expects speeds in May to decline around 20% to 30% for 6% and lower coupons, with higher coupons falling around 10%. While many vintages will see sharp declines, JPMorgan says it expects turnover on 2003 5.5s will accelerate into the summer with 2003 5s remaining in the double digits. The table below gives consensus predictions on 30-year Fannie Mae and Ginnie Mae speeds.

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