What a week it was! Treasuries received a lot of early week support on equity weakness, topped mid-week by the WorldCom accounting fiasco. When the markets opened on Wednesday following the news, 10-year yields had dropped about 19 basis points from Tuesday's close to below 4.70%. As of mid-day Thursday, yields were back to the high 4.70s.

All of this, of course, sent shivers through the mortgage market last week on potential convexity buying, increasing refinancings, and higher supply. Overall, however, mortgages held up fairly well. While there was convexity buying, it was spread out among Treasurys, swaps, and lower coupon mortgages. Mortgage banker supply, meanwhile, has yet to really materialize. Supply is running at between $1.0 billion and $1.5 billion, though one day saw over $2 billion hit, a good percentage of which was in 15-years. Still, it was in a manageable range. While there was supply-induced spread widening, it attracted hedge funds, money managers, and banks. In addition, Friday's session is expected to draw month-end index buyers. All-in-all, over the Thursday-to-Thursday period, spreads were only one to three basis points wider in 30-year 7% coupons and lower, slightly tighter in 7.5s, and wider in higher coupons.

Between a rock and a hard place

At the moment, the sector is at the proverbial "rock and a hard place." If the market backs up, mortgage banker selling will hit, and if rates dip further, there is substantial refinancing and convexity buying risk.

As has been reported by Bear Stearns, 2001 6.5s total $289 billion outstanding, representing 19% of the conventional 30-year mortgage universe. They say that when the no-point 30-year financing rate moves to between 6.50% and 6.55%, these loans will be refinanceable. This year's 6.5s total $92 billion, and with 2001 included, brings 25% of all conventional 30-year paper exposed to a refinancing risk in a single coupon.

According to Morgan Stanley, if 25% of the market delta hedges, the receiving interest will be above $40 billion in 10-year swap equivalents. The firm also estimates that a mortgage rate of 6.25% will trigger a major prepayment wave, and a rate of 6.45% will trigger intensive convexity hedging activity.

There is concern that the mortgage market won't be able to so easily absorb a substantial increase in supply due to the slower portfolio growth of the GSEs. JPMorgan, however, says that while mortgages are susceptible to widening on a further rally, they believe the widening will remain orderly. They expect a strong backstop bid from the GSEs at the wider spread. In addition, corporate crossover buying should continue on this latest fiasco.

Mortgage Indexes

The Mortgage Bankers Association reported that mortgage applications FINALLY responded to the drop in mortgage rates for the week ending June 21. The Refi Index surged 42% to 2505, which is the second highest level this year, and much greater than was predicted. On January 23, the index hit 2768 and on March 7, the index was at 2352. In addition, the percentage of refinancing applications to total application jumped to 50.0% from just under 44% last week. The MBA also reported a 10% gain to 397 in the Purchase Index. Also of note is the ARM share of applications which rose to 18.6% from 18%. This is the highest ARM share since mid-June 2000 when it reached 19.5%.

Freddie Mac reported that 30-year fixed mortgage rates dropped to eight basis points to 6.55% for the week ending June 28. This is only 10 basis points off the low of 6.45% hit in early November. Further, fees and points held at 0.5 points. According to UBS Warburg, this translates into a rate-cut of about seven basis points. Under this assumption, mortgage rates are equivalent to 6.48% plus 0.8 points.

Freddie Mac also reported that 15-year rates dropped nine basis points to 5.99% with fees and points holding at 0.5; and one-year ARM rates were 4.61% versus 4.60% last week. Fees and points were 0.4.

JPMorgan predicts that with this week's rate declines, the Refi Index will hit the low 3000 level next week.

Prepayments

At current rate levels, mortgages are very close to 6.5s being in-the-money. Currently, UBS Warburg predicts 2001 6s will jump from a May speed of 7% CPR to 14% CPR in August; 6.5s will rise to 26% CPR from 13% CPR; and 7s will gain 15% CPR to 39% CPR.

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