Mortgages were slammed last week on the selloff, magnified by convexity-related selling from mortgage participants. Since Friday, July 11, the 10-year yield has backed up 35 basis points as of mid-day Thursday. At the same time, the increase in yields caused an avalanche of originator supply totaling more than $15 billion over the first half of the week. This was double the previous week's level.

The increased market volatility and supply kept investors at the sidelines for most of the week. Institutional accounts started to appear late Wednesday to take advantage of the cheaper price levels. As a result, spreads widened about eight basis points on 30-year Fannie Mae 5s through 6s. Meanwhile, 15-year widening was limited for 4.5s and 5.5s, but similar for 5s.

In comments from RBS Greenwich Capital, analysts note that while the relative value of passthroughs is compelling, it may be wiser to wait for further weakness, as "cheap securities can get cheaper before they richen." Longer term, the sector remains favorable. As one trader noted, Chairman Alan Greenspan's suggestion that the Fed intends to keep interest rates low for some time makes mortgages attractive, although directional.

In addition, the sector is still benefiting from technicals. According to JPMorgan Securities, July should be the highest prepayment month on record with nearly $200 billion in fixed-rate paydowns. Analysts argued that reinvestment dollars should be substantial, but there is a very real risk of a rate whipsaw due to high duration demand and declining MBS supply.

This latest selloff brought extension risk to the front burner (see related story on p.15). According to Lehman Brothers, the duration of the MBS market has extended by nearly $300 billion in 10-year equivalents. Another 50 basis point selloff will extend the market by an additional $330 billion in 10 years, calculates Lehman. An increase in rates to levels where less than 60% of the mortgage market is refinanceable will result in sharp extension risk, says the firm. At this time, Citigroup estimates that 60% of the mortgage universe is still refinanceable.

Mortgage applications mixed

For the week ending July 11, mortgage applications were down just slightly, according to the Mortgage Bankers Association (MBA). On a seasonally adjusted basis, the Purchase Index rose 8% to 447, while the Refi Index was down 1.6% to 6657. Analysts had expected the Refi Index to report in at the low-6000 area. On an unadjusted basis, the Purchase Index gained 23% and the Refi Index surged 35%. Citigroup suggests that the reason for the small decline in the Refi Index is that the MBA underestimated the strength of the holiday-related slowdown during the Fourth of July week.

As a percentage of total applications, refinancings were 70.1% versus 72.1% in the previous report. The ARM share rose to 15.4% to 13.6% as rates increased.

Of note in application activity, says Citigroup, is that the government index has grown faster - or decreased more slowly than the conventional index - over the past couple of months. This suggests that Ginnie Mae speeds may experience larger increases versus conventionals in July. This is supported by UBS Warburg, which calculates that speeds on 2002 GNMA 5.5s will increase 38% to 49% CPR and 6s will rise 22% to 67% CPR. Meanwhile, 2002 5.5% and 6% Fannies are predicted to increase 31% and 16%, respectively, to 36% and 71% CPR.

Mortgage rates increase

more than expected

Freddie Mac reported a 15-basis point jump in fixed-rate mortgage rates for the week ending July 18. The 30-year fixed-rate mortgage rate reported in at 5.67% versus expectations of 5.55% to 5.60%. The 15-year fixed mortgage rate increased to 5.00% from 4.85%. Finally, the one-year ARM rate rose just three basis points to 3.58%.

Looking ahead to this week's MBA report, Lehman expects the Refi Index to fall 15% to 20% due to the increase in mortgage rates.

The impact of higher rates is not expected to hit prepayments until the September report. Right now, Lehman predicts September speeds on 30-year Fannie Maes to be at or near June's levels. The table shows their current expectations regarding prepayments for certain coupons and vintages.

Second-half outlook for CMBS

The CMBS sector has continued to benefit from strong technicals, which have moved spreads to record tight levels - 35 basis points over swaps for 10-year triple-A tranches, according to Credit Suisse First Boston. Lehman says that despite the strong run so far this year, it maintains a mild overweight recommendation for the sector. Furthermore, Lehman expects demand to remain strong in the second half of this year. As for issuance, CSFB expects domestic supply to be around $70 billion this year, up from $60 billion in 2002.

Within the CMBS sector, Lehman recommends a mild overweight to triple tranches. They predict that a strong bid for the sector will prevent significant spread widening. Regarding mezzanine classes, they recommend a mild underweight on concerns that new issue credit spreads are poised to widen. In addition, they believe there is increasing risk of downgrades on seasoned bonds.

Versus other sectors, Lehman recommends investors underweight mezzanine CMBS versus corporates, and to overweight triple-A current payers versus agency debentures. Finally, they are neutral relative to MBS.

For the first six months of the year, domestic issuance totaled $40 billion, according to CSFB. They note that CMBS conduits in 2003 represented 58% of the market, floating-rate deals 17% and single-borrower transactions 7%. One of the more significant shifts in the sector, says CSFB, is the increase in fusion deals. These deals comprised 95% in 2003 versus 83% in 2002 and 68% in 2001.

Also of note has been the increase in the concentration of top 10 loans in conduits: 43.3% versus 37.9% in 2002. Aside from this, triple-A subordination levels also continue to decline. In 2003, it has averaged 16.9% versus 28.8% in 1998.

As stated above, current triple-A 10-year CMBS spreads are at their tightest level at 35 basis points over swaps. Meanwhile, double-A and triple-B spreads are at post-1998 tights, says CSFB, while single-A spreads are at their all-time tights of 49 basis points over swaps. On the other hand, triple-B minus spreads are wider than tights of 2002, 2000, and 1998.

As for the CMBS credit curve, CSFB says that the AAA/BBB credit curve has tightened 28 basis points since the end of 2002, and is just five basis points wider than its record 1998 tight of 55 basis points. In comparison, the BBB/BBB- gap has moved to 55 basis points from 40 basis points, the widest move since 1999.

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