Last week's activity was all about buying. Substantial widening followed the Federal Open Market Committee's meeting, and spreads moved further on the April employment report, but investors just had to step in, as the sector was too attractive to ignore.

Support came from banks, insurance companies, dealers, and hedge funds covering shorts. Interest focus was primarily in 30-year 5.5s and 6s due to attractive carry. At the same time, originator supply was relatively light at around $1 billion per day on average.

Over the week, spreads on 30-year Fannie Maes tightened four basis points for 4.5%, 5% and 6.5% coupons; and six and seven basis points, respectively, for 5.5s and 6s. Dwarf 4s were 10 basis points better, while 4.5s through 5.5s were six to seven basis points firmer.

Most of the Street is positive on the sector, citing favorable technicals, good fundamentals, continuation of the carry trade, improving convexity, and expectations that banks won't be jumping ship anytime soon. Rather, analysts generally expect banks to reinvest less in MBS as their C&I lending picks up (see story p. 14). Countrywide Securities cautions, however, that mortgages are likely to be highly rate-directional, though with a counterintuitive pattern: higher coupons should outperform in uptrades while lower coupons should do better in sell-offs. Countrywide says this is because higher coupons perform well due to curve steepening in rallies. In a sell-off, the premium sector has greater extension risk.

Refinancings fall as mortgage rates spike

Mortgage application activity was mixed for the week ending May 7 with refinancings declining and purchases rising. According to the Mortgage Bankers Association, the Purchase Index rose over 2% to 494, while the Refi Index fell 13% to 2185. This was in line with Street expectations. As a percentage of total application activity, refinancings were 39.8% versus 44.0% in the previous report. At the same time, ARM share hit 34.8%, its highest level in nearly 10-years, said the MBA. This compares to 32.1% in the previous release.

As expected, mortgage rates rose sharply in response to the recent sell-off. According to Freddie Mac's mortgage rate survey, the 30-year fixed rate mortgage rate jumped 22 basis points to 6.34% for the week ending May 14. This was less than the expected 6.40% area that Countrywide Securities had predicted. Mortgage rates are now 96 basis points above their 2004 low of 5.38% on March 18, and are within 10 basis points of 2003's high of 6.44%, hit in early September.

Freddie Mac also reported that 15-year fixed rate mortgage rates increased to 5.72% from 5.47%, a 25 basis point rise. Last, one-year ARM rates gained 14 basis points to 3.90%. Given the sharp increase in mortgage rates in the past week, JPMorgan Securities predicts the Refi Index will print in the 1700 area next week.

Bear Stearns says that, at current rate levels, only around 20% of the MBS universe is now refinanceable. In addition, they calculate that the average borrower refinancing incentive is now a disincentive at negative 24 basis points.

With the increase in mortgage rates, prepayment speeds are predicted to drop dramatically in the months ahead. Consensus predicts speeds on 30-year Fannies to fall 15% to 30% in May, 20% to 30% more in June, and another 20% to 30% in July. For example, 2003 5.5s are predicted to prepay at 23% CPR, down 35% from April, fall another 39% to 14% CPR in June, and by July be at 11% CPR, a 30% decline from the previous month.

What's the convexity risk?

Extension risk was a big topic in last week's research. Some analysts believe extension is still a strong risk, while others argue it has dropped substantially. RBS Greenwich Capital's Linda Lowell commented that, with the strong back-up in rates, 63% of the 30-year market is now priced at a discount and is well extended. She added that, with the largest amount of extension risk behind, the MBS market has less ability to generate destabilizing hedging flows if rates back up further.

Banc of America, however, argues that extension risk in servicer portfolios is now about 20% higher than it was three weeks ago. Extension risk in servicer portfolios is not going away anytime soon even if rates move up by 75 to 100 basis points. As a result, BofA expects active servicer selling to continue if rates rise further. In addition, they say that extension risk in the fixed-rate MBS market remains very high. While convexity hedging-related selling by mortgage investors hasn't been a big story yet, BofA expects it to play a noticeable role in the relative performance of mortgages if rates continue rising.

In a report earlier this month addressing extension risk concerns, Countrywide commented that investors should not fear a repeat of last summer. Most of the extension in the active and liquid part of the market has already occurred, according to Countrywide. One difference, they noted, regarding current conditions versus last summer is the size of "fast money" positions in MBS. Dealer positions were at their largest levels in over five years last summer. Dealers are currently at around one-third of those levels, so they weren't caught "painfully offside" in the latest downtrade like they were last year. Servicers are a concern as the increase in rates has exacerbated the negative convexity in their portfolios. As a result, Countrywide warns that servicers could be net buyers of optionality in the weeks ahead, which could increase implied vols and cause mortgages to underperform in the near term.

Meanwhile, Lehman Brothers expressed concern about increased convexity flows in the coming weeks. While Lehman doesn't see a repeat of July 2003, there are significant rebalancing needs in the market as the duration of the MBS Index has extended by around $550 billion in 10-year equivalents since mid-March.

In Bear Stearns' report, analysts note the convexity trade is in its tail end with mortgages extending at a significantly smaller pace then previously. To illustrate this, they note that on the previous two payroll report releases, the current coupon mortgage rate changed by about 20 basis points. In the April release, this caused the duration of the mortgage market to increase by $182 billion 10-year equivalents, while in May the duration increased just $48 billion. Bear adds that for mortgage portfolios that actively hedge, the duration of the instruments are likely changing at a relatively faster rate than previously. In general, they say, there is less concentration of convexity in the basket of hedges than in the mortgage portfolios. As a result, they see the convexity trading theme fading as the market prepares for Fed tightening.

UBS states that, currently, the convexity needs of mortgage participants are as light as they have been since late 2000. This suggests that participants are less able to exaggerate rate moves than they have in previous times, such as late July 2003.

In UBS' report, researchers note that extension risk is pretty much over. Only 11% of the market is fully refinanceable, while 25% is marginally, UBS said, adding that each 50-basis-point increase in rates from current levels will cause mortgages to lengthen by less than a half year in duration. In fact, contraction risk is a bigger factor. For example, the duration of the 30-year Fannie Mae market is currently 4.89 years, says UBS. If rates increase 50 basis points, duration increases to 5.30 years, or 0.41 years. If rates increase another 50 basis points, the extension is 0.23 years. On the other hand, if rates decline 50 basis points, the market contracts by 0.72 years to 4.17 years, and an additional 50 basis point drop contracts the market to 2.95 years, or 1.22 years.

Regarding the convexity needs of the specific groups of participants - investors, servicers and originators - UBS finds them significantly reduced. Looking first at investors, with the average dollar price of the market at around 98, the convexity needs are now $27 billion 10-year equivalents per each 50 basis point change in rates. In early April, when the average dollar price of the market was 101.5, the convexity needs of investors were around $54 billion. The convexity needs of the second group - servicers - are currently around $23 billion, says UBS. This compares to $30 billion in April. Finally, for originators, convexity needs are now around $32 billion compared to $40 billion to $45 billion in April, and $57 billion to $58 billion in March.

Fed releases quarterly SLO survey

The Federal Reserve recently released its quarterly Senior Loan Officer Opinion Survey on Bank Lending Practices covering the period February through April. Overall, there has been an easing in lending standards, and some increase in demand. Regarding C&I lending over the past three months, the survey reported a slight increase in easing of domestic bank lending standards for large and middle-market firms. About 23% had eased somewhat, up from 18% in the previous survey. Meanwhile, 77% said their standards were basically unchanged versus 82% previously. Demand for C&I loans is also up from the previous survey. As for demand from large and middle-market firms, 39% of respondents said it was moderately to substantially stronger versus 23% in the last survey. The primary reasons for the improvement include increased financing needs for customer inventory, increased investment in plant and equipment, and increased M&A financing needs.

The number of inquiries has also improved from the previous survey. Over the past three months, 55% of the respondents said it had increased "moderately to substantially" versus 40% previously. Regarding commercial real estate lending, the survey reported an increase in easing standards. The percentage of firms that said they had eased somewhat increased to 14.3% from 7.3%. At the same time, demand has increased very slightly, with 32.2% seeing an increase versus 29.1% previously.

Finally, regarding residential mortgage loans, credit standards have also eased somewhat, as 9.8% of firms reported easing versus 3.8% in the last survey. The demand to purchase homes is also up sharply over the past three months as rates dropped: 17.7% of respondents said it was moderately to substantially stronger versus just 1.9% previously.

So what does this mean for MBS? Bear Stearns says that as C&I borrowers draw down on funds, marginal dollars that banks have to invest in MBS will be taken away. Also, as C&I lending picks up, banks are likely to reallocate MBS portfolio run-off into new C&I loans. Banks are not likely to sell MBS due to losses. Finally, Bear Stearns notes that, even if C&I demand continues to increase, banks looking for rapid asset growth could remain net buyers of MBS.

Possibly limiting the impact of lower bank demand, supply is expected to decline due to the sharp drop in refinancings. In calculations from UBS, they project agency fixed-rate supply to peak in May at $104 billion, then decline to about $60 billion in August.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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