It is currently a difficult environment for mortgages as the market tries to find a new range and investors try to gauge potential convexity selling risks. In this situation, mortgages in general will strengthen in a rally and weaken in a sell-off. This was how mortgages behaved in the early part of last week. With the market holding stable to slightly higher, real money and relative value accounts took advantage of the sector's recent cheapening and lack of servicer selling to add bonds.

Mortgages, however, didn't go along with the new playbook when the market began to rally strongly Wednesday and in early trading on Thursday on the negative General Motors Corp. news. The sharp move higher in prices encouraged many participants to move to the sidelines or take profits on the recent gains. In comments from JPMorgan Securities, analysts suggested the MBS response might be in sympathy with the credit spread widening. The market instability, along with the looming Federal Open Market Committee meeting and upcoming PPI and CPI reports, may have also contributed to the limited participation.

Also impacting the sector is that dealer positions have increased as a result of the recent sell-off. Overhanging the market, as well, is the limited support from the GSEs. Finally, there is the question about future bank support. JPMorgan said recently that C&I demand may be accelerating. Analysts note that in the first week of March, banks added $4.8 billion in C&I loans, and both large and small banks are experiencing increased loan demand. "Historically, accelerating loan demand (with a stable deposit base) has led to a decline in the growth of MBS holdings (and occasionally a net drop)," analysts at JPMorgan say.

Originator selling, meanwhile, kept to its average of around $1 billion per day. Servicer selling was limited last week too as the market strengthened on the flight-to-quality bid following the GM news. There is concern among mortgage participants of strong servicer selling if the 10-year Treasury yield tops 4.60%, but is it overplayed? UBS thinks so. For example, in the market sell-off during the first two weeks of March, servicer convexity hedging needs were much less versus either originators or investors, noted UBS. Most market participants would probably agree, said UBS, that convexity selling as the market sold off was much less than was expected. Therefore, if the market sells off going forward, analysts believe market participants will be more relaxed about it.

Application activity increases despite jump in rates

Mortgage application activity unexpectedly rose for the week ending March 11, apparently on borrower fears that future rates will be higher. The Mortgage Bankers Association reported last week that the Purchase Index gained 2.5% to 463, while the Refinance Index was up 4% to 2268. As a percentage of total application activity, refinancings were little changed at 42.9% versus 42.6% in the previous report. ARM share, however, increased to 32.4% from 30.5%.

As expected, mortgage rates were mostly higher, according to Freddie Mac's weekly primary mortgage market survey. The 30-year fixed rate mortgage rate rose 10 basis points to 5.95%. Since hitting a 2005 low of 5.57% early last month, 30-year mortgage rates have surged 38 basis points.

Freddie Mac also reported that the 15-year fixed rate mortgage rate and the 5/1 hybrid ARM rates were both up nine basis points to 5.47% and 5.31%, respectively. Finally, the one-year ARM rate declined to 4.20% from 4.24%.

Looking ahead to this week's MBA report, the Refi Index is anticipated to move back towards the 2100 area, JPMorgan says. And should rates hold near current levels, the index is predicted to approach 2000 in coming weeks, analysts from Lehman Brothers state.

March prepayments expected to jump

Prepayments are expected to jump in March - around 25% for most FNMA coupons though 5.5% coupons are predicted to be up 35%. GNMAs are anticipated to increase around 15% with 5.5s 20% higher from February. The surge is the result of the decline in mortgage rates in February and an increase in the day count. Freddie Mac reported that the 30-year mortgage rate averaged 5.63% in February versus 5.71% in January and 5.75% in December. The day count is 22.5 days in March, versus 19.5 days in February.

In April, prepayments are predicted to decline 10% to 15% for both Fannies and Ginnies, the result of gains in mortgage rates as well as a lower 21-day count. Similar percentage declines are predicted for May at this time.

Copyright 2005 Thomson Media Inc. All Rights Reserved.

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