With the refinance wave losing steam in a shrinking premium universe, declining issuance is a favorable factor for mortgage-backeds, analysts said. This is despite fixed-rate mortgages still appearing rich versus historical benchmarks, researchers from Morgan Stanley argue.

In a recent report, analysts studied historical production dynamics in the mortgage market as well as projections for the next few months. They included mortgage production, in both securitized and whole-loan form.

"We do believe that changing supply has a transitory valuation impact since it necessitates portfolio rebalancing," wrote analysts from the firm. The relevant figure, they said, is net rather than total production.

Valuations are rich and either mortgage spreads should widen or long-dated volatility should drop, they contend. However, low net production might prolong the adjustment process until the first quarter of next year.

According to the report, gross mortgage production will probably drop off by 35% in the fourth quarter. In addition, further declines of 12% are expected in the first quarter of next year. These drops are mainly due to a dip in pay-downs.

Net mortgage production is expected to drop by much less as new home sales and existing home sales (which are considered the major components of net issuance) continue to be strong, researchers said.

Morgan Stanley also said that fixed-rate issuance of agency product (GNMA and Conventional) has averaged 31% of net fixed-rate production over 2003.

Given a similar ratio going forward, analysts predict fixed-rate issuance will dip to $29 billion in Q4 2003, and even further to $15 billion in Q1 2004. This is in contrast to the $44 billion quarterly run-rate in the first three quarters of this year.

A notable event is the recent change in borrower preference, as many of them move into ARMs and hybrids. The trend of declining net fixed-rate production and rising net ARM production is a result of the significant increase in ARM to fixed-rate refinancing (see facing page). The ARM share in total mortgage applications has steadily increased in the last three months to 26% in the number of applications and 40% in dollar volume. Although the share of ARM applications was more than 26% during times of high interest rates in the latter part of 1994 and early 2000, these were characterized by low refinancing activity. During this period, the percentage of refinancings was less than 25% of total activity, the Morgan Stanley analysts said.

The share of ARMs is expected to rise under current conditions given that turnover rates on ARMs are higher. In times when refinancing activity has been as high as it is now, the ARM share has typically been 10% to 15%, the analysts wrote. Morgan Stanley attributes the significant ARM share to unusually high fixed-to-ARM refinancing, abruptly stopping fixed-rate net production.


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