Mortgage spreads moved out last week as a result of strong selling from both sides of the fence. Mortgage bankers averaged between $1.5 billion and $2 billion per day compared with about $500 million in the previous week. The increase came in response to the recent decline in mortgage rates. Money managers, banks, arbitrage accounts and servicers sold almost an equal amount. The sector had been near historically rich levels, and investors took the opportunity to cash in. Also contributing to the weakness was the lack of a CMO bid, no GSE support and a backup in market yields.

Over the Wednesday-to-Wednesday period, spreads were one basis point wider in 30-year Fannie Mae 5s, plus four basis points for 5.5s, and six and three basis points weaker for 6s and 6.5s, respectively. Dwarf 4.5s and 5s moved out five basis points, while 5.5s and 6s were three and two basis points weaker. In early trading on Thursday, spreads were showing improvement as the market rallied on flight-to-quality concerns.

All in all, expectations are for mortgages to grind tighter as technicals dominate. JPMorgan Securities expects nominal spreads to continue narrowing as the market appears to be range-bound. Also, this latest selloff should reduce the risk of refinancing supply. Countrywide Securities suggests, however, that the sector may experience some short-run difficulties due to the following three factors: no CMO bid, a recent increase in net production and low GSE support.

Mortgage Application Activity Mixed

The Mortgage Bankers Association reported a 13.5% seasonally adjusted gain in its Purchase Index to 426 for the week ending Nov. 7. At the same time, the Refi Index fell 2% to 2044. Although the Refi Index was in line with many analysts' expectations, the muted response is surprising considering the decline in mortgage rates over the week. Citigroup suggested that perhaps the half-day adjustment the MBA applied to the Veterans' Day holiday was too small. The lack of response is predicted to reverse next week.

The MBA also reported that, as a percentage of total mortgage applications, refis slipped to 48.1% from 50.9%. ARM share activity, however, rose to 27.5% from 26.6%. MBA Vice President of Research and Economics Jay Brinkman noted, "The ARM share has risen to its highest level in over 3.5 years. Last week, applications for adjustable-rate mortgages comprised 27.5% of total applications and 39.9% of the dollar volume."

At this point, 6% coupons are fully refinanceable, says Citigroup. This means that about 40% of the mortgage universe is refinanceable.

Mortgage Rates Drop on Market Rally

Mortgage rates dropped dramatically last week due to the early week rally. According to Freddie Mac, the 30-year fixed rate mortgage rate fell 20 basis points to 5.83% for the week ending Nov. 21. The 15-year fixed-rate mortgage rate declined to 5.17% from 5.39%, and the one-year ARM rate came in at 3.72% versus 3.76% the week prior.

Analysts expect the MBA will report an increase in its Refi Index next week. Lehman Brothers anticipates the Index will be close to 2500 in the coming weeks. JPMorgan expects the index may rise by 10% to 20%, or in the range of 2200 to 2500. Following this spurt, they anticipate a fall back to 2000 or high 1000s.

Prepayment Outlook

At this time, consensus anticipates speeds on 30-year Fannie 5.5s will run at 14% CPR in November, a 28% decline from 19% CPR in October. Furthermore, 2002 6s are anticipated to prepay at 33%, a 13% decline, while 6.5s and 7s are both expected to slow about 10% - to 47% and 51% CPR, respectively. Looking into December, speeds are predicted to increase in the range of 5% to 10% for 6s through 7s, and jump 20% for 2002 5.5s. Further increases are forecast for January.

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