Mortgages are heading into the summer months in good shape technically. Prepayments are also expected to remain benign unless mortgage rates drop substantially lower.

The one significant event on the horizon is the end of the Federal Reserve's second round of quantitative easing (QE2) on June 30, although no immediate impact on rates or the curve is expected.

Net issuance, which is gross supply minus paydowns, dropped sharply beginning in 2Q11 to more than $4 billion in April from a monthly average of $22 billion in 1Q11.

May paydowns are estimated at $65 billion with month-to-date gross supply through May 23 at $48 billion. This suggests that net issuance will likely be more or less flat.

Barclays Capital analysts said in a recent report that they expect net issuance to remain roughly flat over the coming months for several reasons. There is the low level of new home sales, which is running close to an annual pace of 300,000. They added that even if new home sales should jump by 150,000 annually, the increase in monthly net issuance would be only $2.5 billion, assuming a $200,000 sales price.

Another reason for limited net issuance is negative home price appreciation. Analysts explained that when an existing home is sold and the seller's mortgage is prepaid, the new loan is lower as a result of the lower home valuation.

Home values are expected to decline further. JPMorgan Securities analysts are projecting another 6% drop, with a bottom expected in 1Q12. They added, however, that there is an increasing risk to the downside for home prices.

Barclays analysts also cited the buyouts of delinquent loans. Generally most of the supply coming into the market is from paydowns and sales from the government - Fed, U.S. Treasury, GSEs - which are not reinvested back into the mortgage market. Analysts estimated supply at $25 billion to $30 billion per month and added that this number is also heavily dependent on mortgage rate levels. However, they said that "in the current environment, we expect supply to be fairly benign."

Interest rate levels, the steep yield curve and the weak economic data are expected to keep demand from banks and REITs at high enough levels to offset supply, while increased interest from money managers is expected to show at wider spreads. Morgan Stanley MBS analysts said in a recent report that they believe "the dynamics driving bank and REIT mortgage purchases remain strong."

They also think that these investors will "continue to be a source of support for mortgage valuations over the near to medium term."


Stimulating Prepayments

Prepayment risk remains relatively benign for the mortgage sector, with speeds holding within plus or minus 1 CPR over the near term from April's slower-than-expected pace. Tight credit conditions, weak home valuations and high financing costs prevent many borrowers from being able to refinance through normal channels.

Freddie Mac's recent report on mort- gage rates showed that the 30-year rate averaged 4.61%, with an average 0.7-point. This places the no-point rate at 4.79%. At this level, 5% coupons are in the refinancing window with many borrowers credit-eligible. To start bringing the larger 4.5% coupon into the refinancing window, a decline through 4.5% is needed.


Risks Emerge with QE2 End

The one big event that will occur is the end of QE2 as the Fed completes its $600 billion in Treasury purchases on June 30.

The Fed will continue, however, to reinvest MBS paydowns in Treasurys, although based on the government agency's proposed timeline discussed in the Federal Open Market Committee minutes from its last meeting, the end of reinvestment should be the first step in removing the Fed's accommodative stance.

However, European sovereign debt issues and concerns about global economic growth should keep interest rates low and the curve relatively steep for awhile longer.

Deutsche Bank Securities Head of Securitization and MBS Research Steve Abrahams warned, however, that with the end of QE2, "a force for higher rates steps into the market. Over time - and that could be six to 12 months - that larger force should win." The result will be a flattening of the yield curve, and investors should be making plans to position for this, he said.

For now, "the summer continues to look good for the spread markets," Abrahams said.

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