Mortgages recorded strong two-way flows last week, dominated by roll activity related to 48-hour settlement in 30-year conventionals. As a result, interest was focused primarily in 6s and 6.5s. Over the past week, spreads tightened one to two basis points in conventional currents and nine to sixteen basis points in 7s through 8s.

Ginnie Maes, however, were mostly weaker with the exception of 6s, which tightened two basis points. Six percent coupons through 8s widened one basis point through fourteen basis points, respectively.

The Ginnie sector was hurt, in part, this week by news that the Japanese government was considering a proposal to tax financial institutions on repo transactions involving agencies and mortgage-backed securities. The Japanese government was expected to vote on the issue on Friday, December 14. It is expected that agency MBS will be exempt from the proposed tax.

The MBA reported that its Refi Index declined 10% to 2732 for the week ending December 7. The decline was limited by a brief decline in mortgage rates early in that week. Since the MBA Refi Index peaked at 5535 on November 9, the index has dropped 51% as of last week's release.

Freddie Mac reported a jump in fixed rate mortgage rates to their highest levels since late July. For the week ending December 14, 30-year fixed rate mortgage rates jumped 25 basis points to 7.09%; 15-year fixed mortgage rates surged 27 basis points to 6.57%, while 1-year ARMs fell to 5.19% from 5.21%. Since November 8 when the 30-year hit a low of 6.45%, mortgage rates have backed up 64 basis points.

With the back up in mortgage rates over the past week, further declines in the MBA's Refi Index are anticipated this week to the low/mid 2000 level. This decline supports expectations that speeds most likely will peak in December and start to decline in January.

November Prepayments

Speeds in November jumped again, but this was expected as rates dropped to the 6.51% area and the MBA's Refi Index rose to about 4000, according to Lehman Brothers. Speed increases, however, were less than in October. Fannie Mae speeds rose between 30% and 50% in 6.5s, 20-40% in 7s, and 5-20% in 7.5s and higher. Salomon Smith Barney suggests the smaller increases in 7.5s and above as a combination of burnout and the plateauing of the refinancing curve as the coupon moves deeper into the money.

Speeds on Ginnie Maes were up only modestly relative to conventionals. For example, according to Salomon, aggregate changes in speeds on Ginnie 6s were 22% lower than in October versus +18% for Fannies; 6.5s were up 1% versus 35%; 7s increased 12% versus 32%; 7.5s were up 8% versus 10%; and 8s gained 4% versus 7% for Fannies. Salomon believes the smaller gains could be the result of greater financial hurdles faced by Ginnie Mae borrowers when refinancing, as well as, the fact that the refinancing process for government loans is more of a hassle than for conventionals.

Prepayment Outlook

With mortgage rates substantially higher versus a month ago, the street expects most coupons and vintages to hit peaks in the December report. This report will represent the peak in refi application activity and the absolute low in mortgage rates.

At this time, Lehman expects speeds to increase 20-30% in 30-year conventional 6s and 6.5s; slow in unseasoned/moderately seasoned 7% through 8% vintages, and increase about 10% or less in seasoned issues. Looking ahead to January, Lehman expects speeds to slow about 10% in unseasoned to slightly seasoned coupons and between 20-40% in seasoned coupons. February sees strong slowing at between 30% and 50% from January's levels.

Credit Suisse First Boston, on the other hand, is slightly more aggressive in its December speed expectations. For example, they are predicting speeds on 2000 7.5s to increase to 75% CPR in December from 68% CPR in November, and then declining by over 10% CPR in January.

UBS Warburg expects speeds to increase about 5-10% for most conventional coupons and vintages in December, then plunge 30-40% in January, and a more modest 10-20% in February.

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