Since the beginning of June, the 10-year Treasury yield has dropped about 25 basis points. The decline has been primarily the result of a flight-to-quality related to civil unrest in the middle east; equity weakness on earnings and other headline news; and expectations that the Fed may not start raising rates until after September as the economic picture has not been strong.

The bottom line is that convexity and supply risk have increased and put tension on the mortgage market. Morgan Stanley estimates the cumulative convexity-related duration buying interest has jumped to $44 billion from $8.6 billion in 10-year swap equivalents. Still, mortgage-hedging activity remains muted. Lehman Brothers attributes this to increased volatility through callable issuance as well as greater impairment cushions for servicing portfolios. Lehman says it expects these factors to keep convexity activity less pronounced this time around.

Originator selling has yet to really appear as well. For the past week, it has averaged about $1 billion per day, or less. While money managers, hedge funds and arbitrage accounts have been able to absorb the supply, there is concern that with GSE portfolio growth slower, excess supply will hit spreads hard. While the near term risk of spread widening is high, JPMorgan believes that there is presently a firmer backstop on mortgage spreads than in the fall. In part, this is on expectations of increased GSE demand after two months of flat to declining growth.

Spreads over the Wednesday-to-Wednesday period widened about three to eight basis points in 30-year 6s, 6.5s, and 7.5s, and were weaker by 13 basis points in 7s.

Mortgage Indexes

Last week, the Mortgage Bankers Association reported its seasonally adjusted Refi Index gained only 4% to 1764 despite the fact that mortgage rates are at their lows for this year. In addition, as Salomon Smith Barney notes, the Refi Index has been over 2000 three times earlier this year when rates were at higher levels.

So what gives? Salomon believes that borrowers have had multiple opportunities to refinance. Also, it would seem that mortgage rates just 10 to 20 basis points lower than previous 2002 lows are not enough to get a borrower excited.

Another reason is that borrowers are being advised to wait for potentially lower rates. This suggests that when it looks like rates are at or near their lows, the Refi Index may shoot up, especially as 6.5s move into the refi window of opportunity. Looking to this week's report, Salomon believes the index could increase 100 to 200 points, or 5% to 10%, if rates remain near current levels. The Purchase Index was flat at 359.

Freddie Mac reported lower mortgage rates for the week ending June 21. The 30-year fixed mortgage rate fell eight basis points to 6.63%, and the 15-year fixed rate was down to 6.08% from 6.17% last week. These levels represent the lowest since November 15 2001, when the 30-year rate was 6.51% and the 15-year rate was 6.24%. The one-year ARM rate declined seven basis points to 4.60%. In addition, fees and points are down to 0.5% from around 0.6%-0.7% in the previous reports.

For the week ending June 14, the AFS Title Search Index reported in at 185.6, a 4.9%. increase. The four-week moving average is 173.4, 3.5 points above last week's four-week moving average. According to Paul Descloux, director of the service, title activity is beginning to surge again. Over the past three weeks, title activity is up 15 percent. Descloux notes that the rally on June 14 had some aggressive lenders offering a 30-year loan with no points at a rate of 6.375%.

Refi and prepayment risk

At current levels, the talk is refinancings in the 6.5% coupon. In a recent report, Bear Stearns said that should borrowers be able to secure no-point 30-year financing at 6.50%-6.55%, 2001 conventional 6.5s will become refinanceable. Currently, 19% of the conventional mortgage universe consists of this coupon. The addition, the 2002 vintage adds $92 billion, and raises the percentage of the conventional mortgage universe exposed to refinancing risk to 25%.

With the decline in rates, prepayments are expected to pick up in July and August and UBS Warburg recently raised their predictions. At this time, they forecast unseasoned 6.5s to increase to 25% CPR by August from 13% in May; 2001 vintage 7s to jump to 39% CPR from 25% CPR; 2000 7s to rise to 50% CPR from 34% CPR; and 2001 7.5s to hit 53% CPR from 41% CPR.

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