Last week mortgages benefited from light supply and strong demand from a variety of sources, most notably banks. The previous week's selloff cheapened mortgages up enough to encourage investors to move back into the sector. While mortgages are still on the rich side, the favorable technicals can't be ignored. Also helping has been declining volatility.

As mentioned, the positive tone in the market was set by the noticeable increase in bank activity - finally! JPMorgan says it expects "accelerating demand as bank Treasury portfolios assess the changing market conditions (and improving carry in mortgages as the market sells off and the curve steepens)." At the same time, the technical story in mortgages remains alive and kicking. Originator selling remains fairly light and street inventories are also said to be light. According to Lehman Brothers, carry seems to have potential to dominate again with the Fed anticipated to be on hold through most of 2004. The firm also expects a continued steep yield curve, and the bond market settling into a range.

While the above suggests potential for spread tightening, the sector still has to deal with convexity risk. As a result of higher mortgage rates and a greater proportion of lower coupon mortgages, call risk has increased significantly, says Lehman. According to the firm, "mortgages are unlikely to outperform in a further rally and will potentially suffer in a big downtrade." But maybe not; JPMorgan says the risks in the market have now shifted toward a rally and that mortgages should perform well in a backup.

Over the Wednesday-to-Wednesday period, option-adjusted spreads on 30-year Fannie Mae 5s and 5.5s were three and two basis points tighter, respectively. Meanwhile, 6s and 6.5s were flat to two basis points wider. Also, 15s put in a strong week with bank support tightening spreads eight to ten basis points for 4.5s through 6s.

September prepays slowdown less than expected

Prepayments slowed in September as a result of the summer backup in mortgage rates, however, not to the levels expected. JPMorgan warned that speeds may not decline as much as anticipated as they felt the summer backlog was significant enough to cause a more muted September slowdown.

Bear Stearns also supported this idea, suggesting that the sharp selloff in June sparked a massive rush by borrowers to lock in rates that caused a major pipeline delay. Lehman suggests there was anecdotal evidence of increased mortgage broker solicitations as mortgage rates rose and volume started to fall beginning in June. This could temporarily have slowed the rate of decline in prepayments, said Lehman. The firm also notes the steepening of the yield curve has encouraged fixed-to-ARM refinancings which may also have contributed to the faster speeds.

In comments from FTN Financial Capital Market, Senior Vice President Walt Schmidt noted there was a lesson in this report - that "prepayment risk is still an issue, and may be even more of an issue than investors realize." In particular, investors should be cognizant of the fact that 6.5s and 6s are again in the money, he says.

Fannie Mae 2002 5.5s declined 45% to 26% CPR. Consensus was calling for a 54% slowing to 22% CPR. Meanwhile, 2002 and 2001 6s were predicted to slow about 40% to 40% and 48% CPR, respectively. Instead, the vintages prepaid at 49% and 60% CPR. Also, 6.5s were predicted to slow around 30%; however, they fell about 10% to12% from August's levels. Finally 7% vintages fell 5% to 6% versus expectations of around 15%. The largest percentage declines occurred in 2003 production with 5% coupons falling 30% to 4% CPR, and 5.5s declining 46% to 14% CPR.

Like Fannie Mae, speeds on Ginnie Mae MBS did not fall as much as consensus was predicting for most coupons and vintages. For example, 2002 6s were expected to prepay at 31% CPR, but instead, they came in at 36% CPR. The discrepancy between actual and predicted is even more in the higher coupons. For instance, 2002 7s prepaid at 63% CPR versus expectations of 56% CPR. The table shows prepayments for September for selected 30-year coupons and vintages for all three housing agencies.

Looking ahead to October, Citigroup Global Markets is calling for a 10% to15% drop in aggregate speeds, while JPMorgan anticipates a slowing of 15% to 20%. Lehman suggests that speed declines should be more gradual going forward. Analysts warn, however, that the next two months could be bumpy given the abnormally high count of days for October, followed by an unusually low one for November.

Refi Index surges 20% to 3006

As expected, the Refi Index responded to the decline in rates over the past several weeks. According to the Mortgage Bankers Association (MBA), the Refi Index jumped 20% to 3006 for the week ending Oct. 3. The Purchase Index also was up strongly, gaining 11% to 441. As a percentage of total applications, refis were 55% versus 53.1% in the previous report. The ARM share fell slightly to 22.7% from 23.4%.

For the week ending Oct. 10, mortgage rates reversed on the recent backup, erasing most of the previous week's declines. According to Freddie Mac, the 30-year fixed rate mortgage rate averaged 5.95%, up 18 basis points. This was exactly in line with analysts' expectations. The 15-year fixed-rate mortgage rate reported in at 5.26% versus 5.10% last week, and the one-year ARM fell three basis points to 3.69%.

At current rate levels, Lehman says the Refi Index should fall below 2500 in the coming weeks.

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