As the summer draws to a close, normal trading activity resumed last week with active two-way flows. There was profit taking following Hurricane Katrina while the market sold-off from the previous week's rally. However, flows turned to better buying mid-week from both real and fast money helped in part by paydown reinvestment and a more stable market by Thursday's early trade.
The slight backup and steeper curve encouraged the return of up-in-coupon in 30s - with 5.5s and 6s benefiting. Lower coupons, however, experienced better interest following the August paydown release. Originator selling, meanwhile, picked up from recent daily levels of $1 billion, averaging closer to $1.5 billion last week.
Analysts remained mixed on the MBS sector. UBS recommended holding a modest overweight - despite a lack of overseas buying and bank interest at current levels - because mortgages looked cheap. PIMCO's Bill Gross also noted that mortgages were the only place left for decent yields. By contrast, JPMorgan Securities analysts held with a maximum underweight preference, believing the market's reaction following the hurricane was overdone and that the Federal Opening Market Committee's tightening bias will likely be sustained. Looking towards quarter-end, the outlook would seem less supportive. Generally, fixed income issuance is expected to pick up, particularly in corporates. In addition, securities selling from insurance companies could start emerging as claims are filed resulting from the damage on the Gulf coast.
Mortgage application activity increases
Despite expectations that activity would decline due to the hurricane and pre-Labor Day slowing, mortgage application activity moved higher as borrowers responded to lower interest rates. The Mortgage Bankers Association reported that its Refinancing Index increased nearly 8% to 2357 while the Purchase Index gained 6% to 499 for the week ending Sept. 2. As a percentage of total application activity, refinancings were 44.8%, up from 43.8% in the previous week. ARM share, meanwhile, was lower at 26.5% versus 27.8%.
Mortgage rates remained unchanged to lower for last week as a result of the Katrina-inspired rally. Freddie Mac reported that the 30-year fixed mortgage rate averaged 5.71%, unchanged from the previous week. In other loan programs, 15-year mortgages fell two basis points to 5.30%; 5/1 hybrid ARMs came in at 5.24% versus 5.30% previously; and one-year ARM rates slipped three basis points to 4.45%.
Based on application activity for the week ending Sept. 2, expectations are for activity to hold steady to slightly higher in response to the lower rates, although the holiday and hurricane create some uncertainty. Lehman Brothers analysts recently noted that in normal circumstances, they would expect the Refinancing Index to move towards 2400 if the 10-year holds around 4.08%. But now they expect borrowers could delay refi decisions because of the uncertainty about Katrina's economic impact.
August prepayments mixed
Overall, August Fannie Mae prepayments came in slightly slower than expected. Before the August prepay report's release, the consensus was for a roughly 8% increase. However, fixed rate agency prepayments rose less than 6%. There were a couple of mild surprises in the most recent report. For one, higher coupons prepaid slightly faster. In response to the strength in higher coupon speeds, Bear Stearns Senior Managing Director Dale Westhoff said, "to some extent the surge in seasoned coupon prepayments this month offset their muted response to stronger incentives last month." JPMorgan also noted the muted response of 5% and 5.5% coupons, despite the three additional collection days in August. By contrast, lower coupons are prepaying strong.
Freddie Mac MBS recorded modestly higher percentage increases in August versus FNMAs. Gold speeds, though, remain slower than FNMA counterparts. GNMA speeds were somewhat faster than expected for most coupons and vintages, particularly the higher coupons.
Looking ahead to September, prepayment speeds are expected to drop sharply due to higher mortgage rates, slower seasonals, and a lower day count. Currently, JPMorgan is anticipating a 15% to 20% decline.
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