Despite the increasing risks in the mortgage sector, mortgages have held up well. Spreads in currents and discounts have widened five to six basis points over the Wednesday-to-Wednesday period, while higher coupons have weakened eight to 10 basis points on heightened prepayment concerns. Supply has picked up and is running at about $1 billion per day, with $300 to $500 million in 15s. The supply, however, has been absorbed by active buying from hedge funds, money managers and arbitrage accounts.

What is continuing to support mortgages are the strong rolls, the headline and credit risk issues in corporates, and so far, limited convexity buying in Treasuries. This could deteriorate rapidly, however, if Treasuries rally to 4.95% as convexity hedging would be triggered, says Deutsche Bank's Alec Crawford.

The increase in supply has been manageable and for the moment it should remain so. According to Bear Stearns, the wide spread between the theoretical and consumer mortgage rates suggests originators are trying to restrict volume as they are running at full capacity. If, however, the zero-point 30-year mortgage rate drops to 6.50% and 6.55%, the dam will burst - as 2001 vintage conventional 6.5s would become refinanceable, according to Bear. This comprises 19% of all conventional 30-year MBS, or $289 billion. Adding 2002 production increases the total to $381 billion or 25% of all conventional 30-year paper. Of further note, Bear says that they have never seen a situation where so much collateral could potentially become refinanceable at one time. "The cumulative refinancing exposure of the fixed-rate mortgage market at the 6.50% mortgage rate would be 70%, or $1,722 billion," analyst said.

Mortgage Indexes

The Mortgage Bankers Association reported increases in mortgage application activity for the week ending May 31. The Refi Index was up a subdued 7% to 1596. Salomon Smith Barney attributes the lack of response to the fact that borrowers have already had multiple chances to refinance at current rate levels. They expect that rates would have to rally an additional 40 to 50 basis points to trigger another major refi wave. The big story is the 19% surge in the Purchase Index to a record 414 related to attractive rates and seasonal activity.

Freddie Mac reported on Thursday that mortgage rates declined further for the week ending June 7. The 30-year fixed rate declined five basis points to 6.71%. This is the lowest 30-year fixed rates have been since the 6.51% seen the week of November 16. 15-year fixed rates fell four basis points to 6.18%, while the one-year ARM rate reported in at 4.71% compared to 4.76% previously. Freddie Mac said that the one-year ARM rate has not been this low since April 1, 1994 when it hit 4.65%.

Looking ahead to this week's Refi number, Salomon expects the Refi Index to remain near current levels, adjusted for the holiday. Beyond that, the index is predicted to trend higher should rates hold.

Prepayment outlook

Last Friday, to late to be included in this week's ASR, the GSEs were scheduled to release prepayment data for the month of May. General expectations, however, were for speeds to generally be unchanged to slightly slower with the exception of unseasoned 6s, which were predicted to increase about two CPR.

Looking to June, conventional 30-year Fannie Mae speeds are expected to increase 10% to 20% in most coupons and vintages, though 2001 6.5s are predicted to jump 36% to 16 CPR according to Bear Stearns' outlook. July gains are more modest.

Cash-out refis should continue to support prepayments. According to a report released last week from Freddie Mac, first quarter growth in home values increased by an annual rate of 5.7% nationwide versus 2.7% in the fourth quarter of 2001, and 6.6% from the first quarter of 2001. The Middle Atlantic states showed the most gains, growing at an annualized rate of 8.3%, followed by the Pacific states at 7.5% and New England states at 6.9%. The areas showing the slowest rate of growth at 4% or less were the East South Central states, the Mountain states, and the West South Central states. Freddie Mac's chief economist, Frank Nothaft, said they expect home price growth to slow somewhat over the remainder of the year, "with the average single-family home appreciating between 4% and 5%," he said.

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