Mortgages saw moderate two-way flows last week by a wide range of investors - though fast money was the most dominant player - that kept spreads in a narrow range. At the same time, supply remains at near the $1 billion per session area, and is mostly concentrated in 5.5s. As long as rates hold relatively stable, mortgages are expected to grind tighter, however, sharp moves in either direction are likely to send spreads wider.

The story in the market last week was the continued strength in the FNMA 5 roll due to the strong Mega production in April. While it appears as if there is no available supply in 2005 FNMA 5s, according to JPMorgan Securities, this is not really the case. When the Megas are decomposed into their underlying pools and WALA distribution obtained, JPMorgan says it is apparent that there is a sharp rise in supply for WALAs between 10 and 12. In fact, analysts report it seems there is sufficient supply under 10 WALA to cover shorts, suggesting the roll may be overvalued.

The majority of analysts are neutral to negative on the mortgage sector. In addition, sentiment longer term is less than enthusiastic. Lehman Brothers stated in recent research that "the longer-term prospects for mortgages look grim" for a number of reasons including full valuations, potential for a slowdown in the housing market and turnover and expected decreasing support from the GSEs (see related story, p. 16). Bank support is also becoming less certain. According to Morgan Stanley, recent bank holdings data show that banks have been net sellers of MBS over the past three weeks. Credit Suisse First Boston also points out that the annual growth rate of bank deposits and C&I holdings and mortgage exposure has converged recently. CSFB added that this trend needs to be carefully scrutinized going forward to see what impact, if any, there might be on future bank sponsorship for MBS. On the positive side for mortgages are the favorable technicals. Net supply also remains negative, JPMorgan states.

Mortgage application activity rises

Mortgage application activity rose in the week ending April 22, in response to the decline in mortgage rates. The Mortgage Bankers Association reported that the Purchase Index increased 3% to 482, while the Refinance Index was up 10% to 2053. As a percentage of total application activity, refinancings increased to 39.3% versus 38%; ARMs fell to 34.7% from 35.4%.

"With a 9.8 % increase in applications, refinance activity is at its highest level since March 11," said Michael Cevarr, director of member surveys at the MBA, adding that refinance application volume dropped 14.6% from a year ago.

Freddie Mac reported that mortgage rates declined again, albeit slightly, in its latest survey. Last week the 30-year fixed rate mortgage rate slipped two basis points to 5.78%. This is the fourth consecutive decline, bringing it back to early March levels, but still way above this year's low of 5.57% in mid-February.

In a news release, Freddie Mac Chief Economist Frank Nothaft said that the market was disappointed with the data showing decreasing consumer confidence and orders for durable goods, adding that these numbers imply the Federal Open Market Committee will remain restrained in raising short-term rates. These also indicate the Fed doesn't view inflation to be as great a threat as the markets thought it to be. Nothaft explained that when inflation is perceived to be in check, mortgage rates naturally drift downward, as they did last week.

In other rate products, the 15-year fixed rate fell three basis points to 5.33%; the 5/1 hybrid averaged 5.20% versus 5.22% last week; and the one-year declined five basis points to 4.21%.

With mortgage rates holding stable last week, expectations are for the MBA's Refinance Index to hold in the 2000 area in the next report.

Prepayment outlook

In the past three weeks, 30-year mortgage rates have declined 24 basis points, however, the refi response has been rather muted. According to UBS, the tight trading range that occurred over the August through February period partly caused the lack of borrower response. Analysts said that when rates are generally flat, homeowners become less active in monitoring mortgage rates or refinancing.

The revised prepayment speeds outlook have April speeds slowing about 10% for 30-year FNMA 5.5s through 6.5s, while lower coupons are predicted to be little changed to slightly higher. The April prepayment report will be out on Thursday. Looking ahead to May, similar percentage declines are anticipated for 5.5s and higher coupons, while lower coupons are expected to slow around 5% from April. Currently, June speeds are predicted to be slightly higher.

Copyright 2005 Thomson Media Inc. All Rights Reserved.

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