Despite record high prepayments, mortgages were the second highest performing sector in 2002. According to researchers from Lehman Brothers, through mid-December, the MBS Index outperformed Treasuries by 150 basis points. Mortgages benefited from limited net supply, strong demand, and excellent carry. These same themes are expected to carry over at least through the first quarter of 2003. For the record, the top performing asset class was CMBS, which recorded excess return of 205 basis points through mid-December, while corporates were the worst at minus 250 basis points.

Market activity over the holidays was predictably slow as many participants took time off or closed their books for the year. Over the last 10 days of 2002, Fannie Mae 30-year 5.5s moved out 13 basis points, while 6s through 7s were six basis points wider. Dwarf 5s through 6s weakened six to 11 basis points.

Refi's respond as mortgage rates hit new record lows

For the week ending Dec. 27, mortgage applications were mixed on a seasonally adjusted basis. According to the Mortgage Bankers Association (MBA), the Refi Index rose 11% to 4548 while the Purchase Index fell 7.5% to 332. On an unadjusted basis, however, both indexes plunged. The Refi Index declined 33% to 2729 and the Purchase Index was off 44% to 149. Refi applications as a percent of total applications rose to 75.9% from 72.5% as mortgage rates hit record lows. At the same time, ARM share fell to 11.2% from 13.3%.

As the new year starts off, fixed mortgage rates have sunk to new record lows for the week ending Jan. 3, 2003. As reported by Freddie Mac, 30- and 15-year fixed mortgage rates are at 5.85% and 5.24%, respectively, down eight basis points from the previous week's new records. Meanwhile, the one-year ARM rate came off its lows of last week, rising five basis points to 4.06%.

With mortgage rates at record low levels, analysts from Bear Stearns expects the MBA's Refi Index to pop back up to the 5000 area after the holidays. They add that "with spreads tight for the level of rates, we believe that MBS prepayments may be vulnerable to a stealth' refinancing surge." Their latest prepayment projection is for speeds to decline about 10% in December, fall slightly further in January and increase modestly in February. Beyond that, the researchers predict speeds on 7s and higher to steadily increase through April, while lower coupons will hold or fall slightly from February levels.

December speeds expected to be slightly higher

The housing agencies will release December prepayment reports on Wednesday, Jan. 8. The Street is mixed on whether prepayments will increase or decline from November's levels. An average of several brokerage firm estimates suggest that speeds will increase about 5% for most coupons and vintages. Consensus calls for a 5% decline in January followed by slowing of 8% in February.

Overall, if rates hold around current levels, Bear Stearns expects prepayment speeds to hold near current levels through the middle of next year. On the supply front, Bear predicts that, with no rate backup on the horizon, supply should remain near record levels at least through the first quarter of 2003.

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