Mortgage market activity over the past couple of weeks was generally quiet as many participants were on vacation due to the Christmas and New Year's holidays.

Flows began to pick up on New Year's Eve on month-end extension buying, and have carried over into the first two trading days of 2002. Spread changes since December 21 are mixed. Thirty-year Fannie Mae 6s and 6.5s are unchanged and plus one basis point, 7s are out five basis points, and 7.5s and 8s are one and four basis points tighter, respectively.

Going into 2002, the sector has a favorable bias related primarily to expectations that volatility will decline. Other positive factors include: lower dollar prices, historically wide spreads, declining supply, slowing prepayments, and excellent carry. For these reasons, the street is overweight the sector.

Prepayment outlook

Prepayments are expected to start slowing in the January report, however, larger declines are predicted to hit starting in February based on the sharp drop in the MBA's Refi Index over the past seven weeks due to higher mortgage rates.

As a result of the dramatic increase in mortgage rates, Bear Stearns notes that 40% of the MBS market was removed from any incentive to refinance, leaving less than 50% of the universe refinanceable. By March, the firm expects speeds to be down 30-40% for most coupons and vintages from December's expected levels. At this time, they expect only modest slowing in January, 10% or less, as unprecedented volume works its way through the pipeline. February will see the first large downturn in speeds, mostly in the area of 10-20%.

Salomon also says that the steep drop in refi activity suggests that speeds on cuspy 6.5s and 7s should slow, probably starting in January. UBS Warburg is predicting a sharp drop of about 40% from December's levels for both coupons, followed by declines of between 20-25% in February. Lehman, on the other hand, is predicting declines of about 10-20% in January, then plunging 40-60% on 6.5s and 30-35% on 7s in February.

Mortgage applications

and rates

For the week ending December 28, the MBA announced that its Refi Index fell 38% to 963.5. This week's decline is attributed mostly to the seasonal slowdown rather than to mortgage rates. The index is down 83% from its high of 5534.5 hit November 9, 2001. As a percentage of total applications, refinancings were 50.2%, up from 49.2% in the previous week.

The Purchase Index dropped 41% to 221 after setting a record at 374 the previous week. "Unusually good weather, sustained low fixed mortgage rates, and what appears to be positive attitudes among consumers about the long-term health of the economy have helped sustain the home purchase market at a time of the year when home purchases are generally slow," stated Phil Colling, an economist with the Mortgage Bankers Association of America.

Mortgage rates have held fairly steady to slightly lower during the past two weeks. According to Freddie Mac's Primary Mortgage Market Survey, 30-year fixed mortgage rates dipped two basis points to 7.14% for the week ending January 3, 2002. 15-year fixed mortgage rates fell three basis points to 6.62%, and one-year ARM rates rose one basis point to 5.26%.

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