Mortgages continued to see strong buying interest and limited originator selling last week. Money managers, banks, and arb accounts were the major players. As was the case last week, the focus of investor activity was up in coupon and in 15-year MBS. Over the Wednesday-to-Wednesday period, spreads on 30-year Fannie Mae 6s and 6.5s firmed one to two basis points, while 7s through 8s tightened 12 to 13 basis points. In 15s, spreads moved in four to six basis points on 5.5s and 6s, and 11 to 16 basis points in 6.5s and 7s.

The overall bias for the sector by Street analysts is a slight overweight despite the strong performance put in so far this year. There are some calls for protecting profits, but the prospect for a rangebound market with the Fed move to neutral, declining volatility, attractive spreads, ongoing credit concerns in corporates, and declining supply with strong demand, remain favorable for mortgage performance over the near term.

Mortgage indices portend slowing prepayments

Last week, the MBA announced that its Refi Index fell 21% to 1406. This comes on the heels of a 24% decline in the previous week. As a percentage of total applications, refinancings represented 40%, down from 46.3%. The Street was generally expecting a decline to 1500, though Countrywide Securities noted in comments before the release that it wouldn't be surprised if the number came in around 1400. The MBA also reported that its Purchase Index was little changed at 311 versus 315.

Freddie Mac's Primary Mortgage Market Survey recorded further gains in mortgage rates last week. Mortgage rates rose six basis points for both 30- and 15-year fixed mortgage rates. 30s are now at 7.14%, matching the highest level of this year recorded at the beginning of January. Since February 28, rates have risen 34 basis points. Fifteen-year rates, at 6.65%, are at their highest level for this year, and up 37 basis points from their February 28 lows. Last, one-year ARM rates rose slightly to 5.11% from 5.08%.

Based on the increase, next week's MBA Refi Index should show further slowing. Credit Suisse First Boston is predicting the index to fall to the 1200 level from 1406 this week.

Prepayment outlook

The back up in rates over the past few weeks, has caused some adjustments to prepayments past the March report. At this time, March speeds are expected to increase in the 10-20% range for conventional 7s and below. The Street, however, is mixed on higher coupons. For instance, Lehman Brothers predicts 7.5s and higher to fall 15-20% from February's levels, while UBS Warburg expects modest gains of 5%.

The April report has prepayments essentially flat to slightly lower for both firms. In May, predictions again are mixed with Lehman predicting 7s and seasoned 6.5s to decline around 10%, and other coupons and vintages to be flat to slightly lower. UBS Warburg is forecasting declines of 20-30% for 6s through 7s and slowing of around 10% for higher coupons.

With the slowing, extension risk is becoming an increasing concern, hence the interest in up in coupon trades and in 15-year MBS. In comments regarding this issue, Countrywide says that conventional 6.5s and Ginnie Mae 7s are the most vulnerable coupons at this time.

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