Mortgage performance was improving through midweek, and a major factor for this was the decline in supply compared with the previous week. Originator selling averaged $1.5 billion, down from the daily drops of $3 to $4 billion from the previous week. Supply has been around 75% on 5% coupons and 25% on 4.5s.

Overall MBS volume into last Wednesday was running at about average. Flows were two-way and focused as low as 4% coupons to 6.5%. Interest was focused mostly down-in-coupon with servicers and real money large supporters in 4.5s and 5s. Investors such as foreign central banks and relative value were seen in up-in-coupon trades, while money managers were noted to be two-way in 5.5s through 6.5s. Banks and hedge funds took profits at the improved prices resulting from a strong flight to quality early in the week.

In other mortgage-related activity, specified pools saw relatively heavy volume with $5 billion in selling from bank portfolios over Monday and Tuesday. This contributed to a decline in pay-ups. GNMA/FNMAs were higher partly because of a reduction in supply.

Mortgages recovered nearly 40 basis points in excess return from Dec. 5 through Dec. 9. Barclays Capital reported that the MBS Index lagged Treasurys by 28 basis points month-to-date through Dec. 9. However, it continues to lag ABS (negative 10 basis points) and corporates (negative six basis points). The CMBS Index has surged 561 basis points as investors have decided that the reward in the high-grade tranches more than compensates for the risk.

Mortgage Application Slip

The Mortgage Bankers Association (MBA) reported a decline in application activity for the week ending Dec 5. Previous expectations were for further gains in the index as a result of the decline in mortgage rates. However, the previous week included a seasonal adjustment for the Thanksgiving Day holiday, which was likely a factor in leading to last week's decline.

The MBA said that the Refinance Index slipped 0.9% to 3767.3, while the Purchase Index dropped 17.4% to 298.1. Mortgage rates, meanwhile, held pretty steady with the average contract interest rate on 30-year mortgages falling just two basis points to 5.45% and the one-year ARM rate increasing five basis points to 6.76%.

As a percentage of total application activity, refinancing share rose to 76.7% from 69.1%. The refinance share is at its highest level going back to June 2003. ARM share was 1.1% compared to 1.4% in the last report.

The outlook for mortgages last week was more upbeat. Barclays Capital analysts held their overweight to the mortgage basis as they believe the positives outweigh the negatives. The positives include: the Federal Reserve's plan to buy $500 billion MBS, attractive valuations and the GSE portfolio growth as seen in the October reports. The negative is a potential supply pick-up with the decline in mortgage rates. This could lead to near-term widening in the basis before the Fed gets its program up and running, analysts said.

Prepayment Outlook

With an increase in the day count (three more days) and a surge in refinancing activity in November (over 44% based on November's Refinance Index average), December prepayment speed are expected to jump. These reports will be released in January. Current estimates suggested an increase of 40% with pay-downs totaling in the mid-$40 billion range.

The largest gains are expected in 2007 and 2006 vintages. December's increases, however, will probably be eclipsed by forecasts for January prepayments, which are expected to surge over 100% in terms of conventional speeds, based on mortgage rates that are at record lows.

At around a 5.5% mortgage rate, approximately 50% of the 30-year MBS universe has at least a 50 basis point incentive. If the mortgage rate drops another 100 basis points, nearly 100% of that universe would have an incentive.

The Fed's program to buy MBS should allow mortgage rates to rally even further. An additional 50 basis point drop in mortgage rates would put the mortgage universe into a refinancing wave similar to that seen in 2004, according to Barclays Capital analysts.

Refinancing activity, however, has been very sensitive to the cost of mortgage insurance, g-fees and home price depreciation, which eliminates many borrowers from taking advantage of the attractive mortgage rates.

Barclays analysts projected that if mortgage rates stay close to current levels, speeds on 5.5s and 6s are likely going to be around 35 CPR, and 5s and 6.5s should be at 24 to 27 CPR. If rates drop 50 basis points, analysts projected speeds would pick up to 45 to 50 CPR, which is similar to the 2004 experience.

However, to help more borrowers refinance, government actions to remove or reduce g-fees, mortgage insurance premiums and the re-appraisal requirement for streamlined refinancings are required, which Barclays believes is a possibility. The elimination of these additional costs, along with a decline in mortgage rates to 4.75%, could boost speeds to over 60 CPR, analysts said.

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

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