Volume in the first half of last week was running about average in MBS in two-way flows. In general, hedge funds continued to de-leverage and were actively selling in 5s and 5.5s.

Overseas buyers, money managers and real money investors took advantage of widening spreads on any given day. Spreads on Tuesday moved out to historic wides. As this was occurring, many investors were buying. However, as spreads continued to deteriorate, most investors threw in the towel and sold. Servicers were also heavy sellers on Tuesday at over $3 billion, primarily in 5% and 5.5% coupons.

Spreads opened tighter on Wednesday on better buying from money managers, hedge funds and overseas investors, which more than offset the $2 billion in supply that came in the morning. However, the firmness brought out some active selling, again in the lower part of the stack, to move spreads to flat by late morning, especially as the 10-year Treasury was selling off sharply.

In other sectors, 15s underperformed 30s, while GNMA/FNMA swaps outperformed. Specified pools experienced better selling. Originator selling was averaging about $1.3 billion per day in the first half of the week, down from $2 billion or so in the previous week. Supply was primarily in 5.5% coupons.

Given the market conditions and outlook, it is no surprise that mortgages are off to a bad start in March. Month-to-date through March 4, the Lehman Brothers MBS Index is underperforming Treasurys by 89 basis points. Meanwhile, ABS is off 15 basis points, CMBS is negative 107 basis points and U.S. credit is lagging by 30 basis points.

The employment report was set to be released on Friday after ASR went to press. Typically, mortgages tend to benefit from the drop in volatility following the release. In addition, payroll news corresponds with pay-down reinvestment, also a traditional positive for the sector. However, this outlook is uncertain this month. Mortgages are struggling with a lack of liquidity since many participants have become extremely risk-averse given the worsening outlook for housing and credit. This is keeping many investors limited to a day-trading mode of investing.

There is also the threat of increasing foreclosures. Federal Reserve Chairman Ben Bernanke stated that delinquencies and foreclosures were likely to rise in a recent address before the Independent Community Bankers of America, adding that home prices were probably going to decline further. Given the dire outlook, Bernanke urged lenders to forgive some portion of mortgage debt for homeowners who are at risk of defaulting.

In its latest edition of Short-Term Prepayment Estimates, Bear Stearns highlighted foreclosure risk. "We believe the biggest obstacle to stabilizing the freefall that now consumes the housing sector is containing foreclosure sales," analysts wrote. "The magnitude of this problem is on a scale that has no historical precedent." Analysts estimated that by the end of 2008, national foreclosure starts will exceed 50% of single-family existing home sales.

Analysts also noted that the peak of foreclosure supply is projected to occur by the middle of 2009, increasing another 50% from third quarter 2007 levels. Given the circumstances, some further government programs beyond FHASecure and higher conforming loan limits will likely be required, they said.

Mortgage Outlook

Street analysts' tone was negative last week. Many noted the market's overreaction to the Office of Federal Housing Enterprise Oversight's news about lifting GSE portfolio caps. They noted that the agencies are unlikely to be aggressive in buying MBS, as their focus currently is on the preservation and growth of capital. This is not to mention that the agencies are still under their 30% capital constraints (see story p. 19).

Barclays Capital also said that bank demand is likely to be light as well, as these institutions continue to focus on their capital needs because of their heavy write-downs.

Refi Applications Up 3%

The rally in the last week of February spurred mortgage application activity as mortgage rates declined. The Mortgage Bankers Association reported a 29-basis-point drop in the 30-year fixed contract rate to 5.98%, while the one-year ARM rate was little changed at 5.83% compared to 5.84% in the last report.

For the week ending Feb. 29, the Refinance Index rose 4.5% to 2569, while the Purchase Index gained 1.4% to 363.1. For the month of February, the Refinance Index averaged 3366, down 12% from January's average. The decline resulted from a gain in mortgage rates with the 30-year averaging 16 basis points higher in February at 5.92%. As a percent of total applications, refinancings were 52.4%, up slightly from 52% in the previous report. ARM share was higher at 17.3% compared to 15%.

Prepayment Outlook

Prepayment speeds are seen surging in February due to a sharp drop in mortgage rates and a jump in refinancing activity. For example, the 30-year fixed mortgage rate averaged 5.76% in January compared to 6.10% with December, while the Refinance Index averaged 80% higher at 3838. Contributing to a small offset is a lower day count in February: 19 versus 21 days.

Projections before prepayment reports came out last Thursday suggested that FNMA speeds will jump about 50% overall in February from January. The 2007 and 2006 vintages were expected to surge to nearly 60%, while older vintages are seen gaining around 40%. GNMA speeds are seen increasing much less at around 30% overall on average. Pay-downs are estimated in the high-$40 billion area.

Bear Stearns predicted speeds to be similar to the summer of 1995 and then to slow even further in the second half of this year. Given the housing climate, the lack of response of mortgage rates to the Fed rate cuts, tighter lending standards and higher costs related to fee increases by the GSEs, Bear analysts expect "one of the weakest seasonal spring housing cycles on record."

Before February prepays were released, Bear Stearns projected 2007 and 2006 vintage 6s to prepay at 19 and 20 CPR in February and at 10 to 11 CPR in July. Similar vintage 5.5s were expected at 11 to 13 CPR in February and at 8 to 9 in July.

(c) 2008 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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