It was a sluggish week in mortgages this past session. Spreads were weaker with 30-year Fannie Mae 5.5s widening nine basis points over the Wednesday-to-Wednesday period; 6s and 6.5s were one basis point and flat, respectively; and 7s moved out six basis points. Such was the story in Dwarfs, with 5s weaker by seven basis points, and 5.5s through 6.5s four, three, and two basis points cheaper, respectively.

Buyers were less active than in the previous week as volatility moved higher, and rolls got whacked. It might have been worse had originators been better sellers; however, supply was kept at average to below-average levels.

The supply story, or rather, the lack thereof, continues to be an interesting one. Countrywide Securities noted in a recent report that in addition to the most common reasons stated for the supply drought - increased ARM production and extension of the originator pipeline - is that banks and depositories are retaining production for their portfolios rather than securitizing it. For example, according to Countrywide's research, Washington Mutual's issuance dropped 8% month-over-month. The benefit of this is that it allows banks to reinvest the heavy paydowns from their MBS. If this is happening, it could mitigate the need for banks to replace paydowns by buying securities, says Countrywide.

A few weeks ago, Bear Stearns warned investors that the biggest risk facing mortgages was extension risk. In a report released Sept. 12, Credit Suisse First Boston also noted that the biggest risk is now extension. CSFB reminds investors that 30-year 6s and 6.5s make up nearly 70% of the outstanding agency 30-year MBS universe. "Over the next six months, as borrowers refinance mortgages underlying these pools, we expect the majority of newly originated mortgages to be pooled into 5.5% securities," said analysts from the firm. They project the mortgage market is poised for a 33% increase in duration.

Between duration extension and supply, CSFB expects near-term cheapening in 5.5s. In addition, they believe banks and other short duration investors will be less interested in the low-yielding, longer duration paper. Also impacting the price is high volatility. Vols are predicted to remain elevated for quite some time as mortgage demand remains strong. This will hold as long as mortgage rates remain around record low levels.

Mortgage Indexes

For the week ending Sept. 13, the Mortgage Bankers Association (MBA) reported that mortgage applications on a seasonally adjusted basis declined. The Purchase Index fell 11% to 357 and the Refi Index was off 8% to 5625. On an unadjusted basis, however, the Purchase Index gained 13% and the Refi Index rose 15%. The MBA noted that the Refinance Index has been above 4000 for eight consecutive weeks now, and over 5000 for six of those eight weeks. As a percentage of total applications, refinancings represented 73.6% versus 72.5% in the previous report. The record high is 78.4% set last November. The share of ARM activity ticked upward to 12.5% from 12.3%.

In comments from Countrywide Securities, the firm noted there is some evidence that refi applications are beginning to peak, despite the historically low level of mortgage rates. Countrywide suggests a few factors for this, including: limits on front-end capacity at mortgage banks; stickiness in consumer-mortgage rates; and reluctance by some borrowers who have previously refinanced their loans to go through the process again.

For the week ending Sept. 20, Freddie Mac announced further declines in mortgage rates. The 30-year fixed-rate mortgage rate plunged 13 basis points to 6.05%, and 15-year fixed-rate mortgage rates dropped 12 basis points to 5.47% - both new record lows. Lastly, the one-year ARM rate fell to 4.28% from 4.32%.

Prepayment outlook

With the release of August prepayments, the Street has been updating its expectations for upcoming months. September speeds on Fannie Mae 2001 6s are expected to show even larger percentage gains than reported in August. The coupon is seen increasing 56% to 28% CPR. 2001 6.5s are expected to record a 37% gain versus 52% in August; the CPR is called at 52%. At this time, speeds are predicted to peak in October for most coupons and hold steady in November. Deutsche Bank, however, has speeds on most coupons and vintages peaking in November. In some cases, the peaks are substantially higher than the average estimate. For example, it estimated a 68% CPR on 2001 6.5s versus 61%; a 69% CPR on 2001 7s versus 66%; a 78% CPR on 2000 7s compared to an estimate of 72% CPR; and lastly 2000 7.5s are called at 73% versus 71%.

The story is the same in Ginnie Maes with speeds predicted to increase 38% in September to 18% CPR on 2001 6s. Last year's 2001 vintage 6.5s and 7s are expected to record slightly smaller percentage gains than in August. CPRs are forecasted at 44% and 59% CPR, respectively. Peaks on 2001 6.5s and 7s are predicted to hit in November at 56% CPR and 68% CPR. The prepay table (opposite page) gives the latest outlook on speeds for both Fannie Mae and Ginnie Mae MBS.

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