Mortgages saw active two-way flows last week with strong selling early on, followed by active buying by mid-week on the cheapening and by month-end. On Tuesday, relative value accounts unloaded more than $4 billion, mostly in Fannie Mae 5.5s. Servicers were also active sellers, primarily in 5s and 5.5s. Even originators got into the act, selling about $2 billion that day in 5.5s and 6s. Substantial widening drew in better buying on Wednesday, which continued into Thursday and Friday's sessions. Support came from dealers, banks, money managers and hedge funds with preference in 30-year 5s through 6s, and higher coupon 15s.

Over the Thursday-through-Wednesday period, spreads were flat in 30-year Fannie Mae 4.5s and 5.5s; two basis points wider in 5s; plus three basis points in 6s; and one basis point weaker in 6.5s. In 15s, spreads moved out one basis point in 4s and 4.5s, and were one basis point tighter in 5s and 5.5s.

Analysts remain neutral to positive on the sector. JPMorgan Securities upgraded its recommendation to strong overweight on Wednesday from slightly overweight at the start of the week. The improvement is in anticipation of strong mortgage demand dominated by bank CMO activity and money managers covering both duration and mortgage underweights. While Bear Stearns is neutral, analysts said if mortgage rates move above 6.05%, it would make sense to scale back into an overweight in mortgages.

Mortgage application activity holds steady

The Mortgage Bankers Association reported little change in mortgage application activity for the week ending July 23. The Purchase Index rose 1% to 445, while the Refi Index was virtually flat at 1649 versus 1651 the previous week. Countrywide Securities had expected little change in mortgage applications given the firm's recent experience. It is surprising, however, that activity never really increased, despite the drop in mortgage rates over the past few weeks to below 6%. In a recent report from Countrywide Securities, researchers attributed the lack of response of the Refi Index to both a decline in the number of loans with high fixed note rates and the growing share of the mortgage market comprised of ARM loans. Like fixed rates, WACs on ARMs have declined and Countrywide believes rates would have to drop 25 to 35 basis points in ARM rates to rekindle ARM refinancing to the extent seen earlier in the year. This suggests then that the MBA's Refi Index may continue to exhibit insensitivity to changes in 30-year rates unless ARM rates also move commensurately, the firm said.

As a percentage of total application activity, refinancings fell to 36.8% to 37.1%. At the same time, ARM activity rose to 33.3% from 31.3%

Freddie Mac reports higher mortgage rates

Freddie Mac reported an increase in mortgage rates for the week ending July 30. Both 15- and 30-year fixed rate mortgage rates rose 10 basis points to 5.49% and 6.08%, respectively. This was in line with analysts' expectations. The one-year ARM was also higher at 4.17% versus 4.12% the previous week. With the increase in rates, analysts expect the Refi Index to decline in this week's report to between 1500 and 1600.

Prepayments expected to increase after July decline

In recent comments from JPMorgan, analysts note that month-to-date, the Refinancing Index is around 12% higher than the previous month due to the recent decline in mortgage rates. As a result, speeds are anticipated to increase in the August and September reports, with the greatest gains coming in 5.5s and 6s. Consensus expectations regarding certain coupons and vintages for 30-year Fannie Mae and Ginnie Mae MBS are below. The July prepayment report will be released this Friday.

The GSEs and hybrids

As has been highlighted many times in the past, GSE participation in the fixed-rate MBS market this year has been limited. The option-adjusted spread on par 30-year passthroughs has been below their funding costs for most of the year, according to a recent report from Bear Stearns. The GSEs attribute the tight spreads in the MBS market to bank support, and their higher funding costs this year to Congress' focus on the GSEs.

In this environment, the GSEs have become more active in the ARMs market, analysts state. Almost 40% of Fannie Mae's $87 billion in purchase commitments in the second quarter came in hybrid ARMs or triple-A Libor floaters. This shift has implications for the agency debt market, the options market, not to mention the ARMs market, according to a recent report from Bear Stearns.

Regarding the agency debt market, Bear Stearns analysts say that a shift to shorter durations along with slow to no portfolio growth mean less debt issuance, particularly longer- term issuance. This could lead to a net tightening of agency spreads to swaps, suggests Bear Stearns. In fact, this has begun to show up. For example, two-year spreads have tightened eight basis points in the last 30 trading sessions; and five-year spreads are five basis points tighter over this same timeframe. The firm believes the 10-year area is likely to be next. Analysts note investors can buy the bullet, pay fixed on a swap, and still have positive carry to Libor funding.

In the options market, the shift to ARMs means the GSEs need less long-dated options. Researchers cite a potential drop in GSE demand for long-dated options on five- and 10-year rates and a potential rise in demand for options on shorter parts of the yield curve. To demonstrate, they also note that over a five-year period, assuming there is no change in rates, the duration of a 30-year MBS moves from 5.0 years to 4.1 years. On the other hand, the effective duration on a 5/1 ARM falls from 2.8-years to 0.2-years as the coupon switches from fixed to floating.

Finally, the GSE interest in hybrid ARMs may provide a backstop bid for that sector. "For prospective investors," says Bear Stearns, "this could cushion the spread volatility of a market that continues to build its distribution network."

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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