Mortgage flows picked up last week with steady buying seen primarily from money managers, and a bit of interest from the banks as well. At the same time, originator supply remained light with selling averaging around $1 billion per day. In addition to the favorable technicals that supported mortgages, the sector benefited from Treasury supply, falling volatility, and roll-related trading resulting from the calendar flip on 30-year conventional MBS. The 5% coupons, in particular, benefited. Rolls on 5s richened considerably and were trading just above fail on Thursday, the beginning of 48-hour notification. With the front-month supply in Fannie Mae 5s at over $130 billion net of CMOs, and expected to rise to $160 billion next month, 5s should lose "specialness," according to JPMorgan Securities.

Overall, the rally in rates last week benefited the lower coupons in both the 30- and 15-year sectors. Meanwhile, 30-year Fannie Mae 5% coupons tightened eight basis points over the Wednesday-to-Wednesday period, 5.5s moved in two basis points, and Dwarf 4.5s were firmer by five basis points. Other coupons in both sectors were wider.

Analysts are mixed on the sector. UBS Warburg recommends holding with a modest overweight due to limited supply, decent demand and Treasury auctions. RBS Greenwich Capital notes that mortgages appear to be slightly cheap with 4.5s and 6s as the cheapest. At the same time, JPMorgan and Lehman Brothers remain cautious on the sector.

Refi Index surges 46% to 2884

The Mortgage Bankers Association (MBA) reported gains in mortgage applications on a seasonally adjusted basis for the week ending Sept. 5. The Purchase Index rose 3% to 409, while the Refinancing Index surged 46% to 2884. Analysts were expecting the index to hold near the previous week's 1982 level. On an unadjusted basis, the Purchase Index fell 19% to 324, but the Refi Index increased 16% to 2307. As a percentage of total applications, refinancings jumped to 55% from 45.9% in the previous report. At the same time, ARM share slipped to 21.6% from 23.3%.

Market participants were surprised by the increase, but they attribute the gain to the recent rally in mortgage rates, combined with inactivity in August and many potential borrowers on vacation or focused on getting children back to school. Citigroup Capital Markets also suggested the possibility of lender solicitation targeting more seasonal loans. The firm noted that the average loan size of refinancings fell to $159,000 from $187,000.

With rates rallying, will refinancings take off again? JPMorgan says that if rates rally another 25 basis points, they would expect the Refi Index to move to over 5000. Looking ahead to this week's number, Lehman says if rates remain below 6%, the firm expects the index to stay above 2000.

Freddie Mac reported significant declines in mortgage rates for the week ending Sept. 12. The 30-year fixed-rate mortgage rate fell 28 basis points to 6.16%; the 15-year fixed-rate mortgage rate declined to 5.46% from 5.77%; and the one-year ARM reported in at 3.87%, down 11 basis points from last week.

August prepays not in line with expectations

While Fannie Mae MBS speeds slowed in August, the declines were less than consensus was anticipating for many coupons and vintages, particularly for older vintages. For example, 2001 6s prepaid at 76% CPR versus expectations of 68% CPR; 2002 and 2001 6.5s prepaid at 72% and 77% CPR, respectively, versus predictions of 68% and 72% CPR; and 2002 and 2001 7s prepaid at 64% and 70% CPR, respectively, versus expectations of 60% and 64%. Citigroup suggests that at the height of the refi wave, originators focused on the easier to refinance and more profitable newer cuspy coupons, but as new applications slowed down on the rate increase they were able to focus their attention on the more seasoned and higher coupon issues.

Speeds on Freddie Mac mortgages recorded larger percentage declines than Fannies; however, speeds remain slightly elevated to their Fannie counterparts. Bear Stearns says it expects this trend to continue with full convergence in speeds by year-end.

Ginnie Mae speeds also were mixed versus expectations. For example, the 2002 vintage 5.5s and 6s slowed substantially more than consensus was predicting while higher coupons and older vintages slowed less than forecasts. Also of note, the 5.5% and 6% coupons slowed more than their conventional counterparts. Citigroup says that government loans tend to close at the end of the month rather than spilling over into the next month, and so could reflect the higher rates seen at the end of July and beginning of August.

At this time, analysts expect dramatic slowing in prepayment speeds to be reported throughout the month, with more moderate declines from October on. The September report will reflect a 69 basis point increase in the lagged mortgage rate, a 50% decline in the lagged refinancing index, and a 31% decrease in the lagged title search index, according to Bear Stearns. At this time, speeds on 2002 and 2001 5.5 through 6.5 FNMA vintages are predicted to slow 30% to 60% from August's levels, while 7s are expected to slow about 14% from August.

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