With the refinancing boom over, the mortgage fixed-rate supply should plunge, along with the drop in issuance of 15-year product, analysts said. However, an increase in Ginnie Mae paper and a growing hybrid ARM share are on the horizon.

In a recent report, UBS said that the drop in fixed-rate supply would be particularly significant. The report noted that fixed-rate Agency supply has declined to $83.2 billion in December from $92.2 billion in November, and, even more telling, from $186.8 billion in August. The firm is predicting only $73.8 billion this month and $71.5 billion in February.

Meanwhile, 15-year production has currently fallen to 22.8% of the fixed-rate segment from 30% of fixed-rate in the first nine months of last year. UBS thinks that the 15-year share will be dropping further, to the range of 18% to 20%.

The drop in fixed is not reflected in other products. Specifically, ARM applications had increased to 30% from a range of 15% to 20% during the first half of 2003.

Meanwhile, Ginnie's share of the total increased to 12.5% from 10%. Analysts predict that this will rise further to a minimum of 15%.

The coupon composition of the mortgage market is also drastically different compared to a year ago. UBS said at the end of 2002, the Fannie Mae 6.5% coupon comprised almost 40% of 30-year Fannie outstandings. However, this has fallen to only 14%. Meanwhile, 30-year Fannie Mae MBS with coupons less than or equal to 5.5% made up just 6% of all mortgages at the end of 2002. Currently, they represent 56%.

UBS said that the reshaping of the mortgage market has two implications. First, higher-coupon mortgages are expected to be scarce compared to a year ago, and secondly, the reshaping of the mortgage universe toward lower coupons suggests that it will require even lower rates to re-ignite the refi boom.

"We believe that, at this juncture, the key to outperforming a mortgage index is to focus on fundamental factors that have changed with the end of the refi wave - prepayment behavior and supply," wrote analysts. "In the prepayment area, there's a very different response during a refi frenzy from that during a normal' environment."

Deutsche Bank, in its most recent Securitization Monthly, said that mortgages actually benefited toward the end of last year from a tight range of interest rates, and prepayments have slowed with the "been there, done that" attitude of mortgage borrowers to refinancing.

However, if mortgage rates break the lower bound of the 5.75% to 6.25% range then homeowners - specifically those with 6% and 6.5% coupon mortgages - would probably re-ignite the currently burned-out refinancing activity.

But Deutsche said that if rates break out of the range on the high side, as priced into the yield curve, then refinancing would likely fade further. However, this would not adversely affect prepayments on discount coupons, said analysts. Whether higher rates were caused by growth or by inflation, either would probably be supportive of housing prices and homeowner equity. Both, in turn, support the trade-ups and cashouts that drive prepayments in low-coupon mortgages.

"In short, when the 30-year mortgage rate eventually does escape its 5.75% to 6.25% range, we think unpleasant prepayment surprises would be more likely in the low-rate scenario than in the high-rate scenario," wrote analysts at the firm.

Gross supply in 2004 will probably remain light although Deutsche predicts net supply will return to historically average levels across the various sectors as a steepening yield curve pushes net supply into a more balanced position.

Supply as a valuation tool

Merrill Lynch, in a recent report, argued that supply is a way of measuring prepayment activity, but it might not be the best determinant of relative value. Supply tends to be a lagging indicator as it takes awhile for loans to be prepaid, Merrill said. Aside from this, it also takes time for loans to be reissued as new passthroughs.

A better indicator of the level of prepayment and supply risk is the index itself and the degree that it's in or out of the money. For instance, Merrill said that one year ago the average conventional 30-year coupon was 6.49%, while currently it is 5.79%, which is a drop of 70 basis points in 12 months. Thus, the mortgage index is considerably less at the cusp of a refinancing wave now compared to one year ago, even though the mortgage current coupon yields are comparatively alike.

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