Last week was an interesting week in mortgages to say the least. Monday saw active buying all across the coupon stack following the larger-than-expected decline in prepayments. Higher coupons, in particular, experienced the greatest gains as a result of the prepayment report.

The environment changed Tuesday when the market rallied, bringing the 10-year Treasury to 4.02%. It was even uglier on Wednesday when the 10-year closed at 3.98% following a favorable five-year auction. Profit taking emerged, volatility moved higher, and buyers moved to the sidelines on concerns about potential supply and refinancings as mortgage rates moved below 5.60%. In comments from Bear Stearns' senior managing director Dale Westhoff, he said that for every basis point below 5.60% that mortgage rates decline, $30 billion in agency fixed rate mortgages become refinanceable (see related story p. 15).

Thursday afternoon the market started to recover following the weaker than expected 10-year Treasury auction that sent prices tumbling and provided an opportunity for investors to take advantage of the mid-week widening. Meanwhile, 15s caught a bid on curve steepening and recent cheapening. Originator selling, meanwhile, remained manageable throughout the week, averaging slightly over $1 billion per day on average. Most of the supply was in 5.5s, though there was some 4.5s starting to be seen.

At this point, mortgages are expected to be directional - lagging on rallies, and strengthening on sell-offs - if yields hold in the lower end of the 4% to 4.30% trading range.

Mortgage application activity up 4% overall

Mortgage application activity rose for the week ending Feb. 4, but was somewhat less than expected. According to the Mortgage Bankers Association, the Purchase Index rose 1% to 445, while the Refinance Index gained 8% to 2431. Countrywide Securities said that during the week the firm experienced a 9% increase in purchases and a 15% rise in refinancings. Countrywide tends to lead the market, however, which suggests this week's MBA report will show strong gains.

As a percentage of total application activity, refinancings were essentially unchanged at 48.9% versus 48.7% in the previous release. ARM share slipped to 32.9% from 32.5%.

Not unexpectedly, mortgage rates dropped to the lowest levels since 1Q04. Freddie Mac's Primary Mortgage Market Survey reported last week that the 30-year fixed rate mortgage rate averaged 5.57%, down six basis points from the previous week. This is the lowest since last April when the 30-year was at 5.52%.

Additionally, Freddie Mac reported 15-year rates declined four basis points to 5.10%; the 5/1 hybrid ARM clocked in at 4.99%, virtually unchanged from last week's 5% average; and the one-year ARM fell to 4.11% from 4.23% previously.

Based on the recent decline in mortgage rates, this week's MBA mortgage application survey is expected to show strong gains. Lehman Brothers said that if rates hold around current levels, the Refinance Index would probably move up to the 2700 to 2800 area in coming weeks.

January prepays decline more than expected

Speeds declined about twice as much as consensus estimates in January for 30-year FNMAs. Expectations were for prepayments to decline between 8% and 10% from December's levels, but speeds dropped around 20% for FNMAs and around 30% for Golds.

Some reasons for the slowing were a lower day-count for this period - 20 days versus 22 days in December. And while mortgage rates have held in a very narrow range in the past several months (Oct: 5.72%; Nov: 5.73%; and Dec: 5.75%), the Refinance Index declined as a result of seasonal factors. For example, in October it averaged 2160, in November it was 2154, and in December it declined to an average of 1841. Regarding the larger slowing in Golds, JPMorgan Securities notes some of this can be attributed to lower loan balances and more favorable geographics.

Like FNMAs, GNMA speeds slowed more than expected, but not to quite the same extent. GNMA prepayments were anticipated to slow around 8% to 10% in 5.5s and higher and hold flat in 5s. Instead, speeds declined around 17% overall in January from December, with the exception of 2004 5.5s and 6s which were little changed.

GNMA speeds remain substantially faster than comparable Fannies. Countrywide analysts recently said, "the transition of GNMA borrowers to the subprime market and the conforming market is probably the chief causes for aberrant prepayments along with buyouts and higher delinquencies."

The preliminary outlook is for speeds to hold in a narrow range in February for 30-year Fannies. The day-count is 19 days versus 20 in January; however, mortgage rates have held within a four basis point range on average over the past three months, while the Refi Index has been on the rise since its traditional holiday malaise. March speeds are predicted to surge over 30%, responding to the latest decline in mortgage rates and improving seasonals.

Copyright 2005 Thomson Media Inc. All Rights Reserved.

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