Last week the influence of volatility on mortgages was very evident. Specifically, volatility ticked much higher on Monday's and Wednesday's trading sessions on a flight to quality bid brought on by weaker global equities, commodities and economic concerns. Spreads on mortgages were considerably wider on these days as well. Absent the safe haven bid on Tuesday's and into Thursday's session, mortgage spreads held slightly firm.

Outside of volatility, flows were modest and two-way. There was buying taking place with broad participation, although with the exception of overseas investors. Buying occurred both up and down the coupon stack and was not all influenced by changes in the curve's shape. Originator selling continues to average about $1 billion per day.

On Tuesday, the Office of Federal Housing Enterprise Oversight issued its long awaited report on Fannie Mae (see story p.1). The OFHEO's list of recommendations includes limiting Fannie Mae's growth due to its "current operational and internal control deficiencies and other risks." Mortgages really didn't respond to the latest news, in part because the accounting scandal and capital surplus charge have limited Fannie Mae's participation in the sector for quite some time now.

May continues to be unkind to mortgages. Month-to-date, the Lehman Brothers MBS Index has recorded an excess return versus Treasurys of -31 basis points. Year-to-date, mortgages performance has deteriorated from a high of 85 basis points through February, to 28 basis points currently.

Market sentiment is neutral to slightly negative at this time. Given the data-dependency of the Federal Reserve, not to mention a nervous global equities market, volatility is expected to continue to weigh on mortgages. Other negatives include high dealer inventories (which stood at $36 billion as of the May 10 close), sidelined overseas investors, limited domestic bank buying at current unattractive yields, and the lack of a clear trading range. Also, with Fannie Mae's agreement with the OFHEO, the GSE appears to be out as a backstop bid. On a positive note, originator selling remains uneventful, and there is potential for crossover buying.

FHLMC net retained portfolio for April dips

Freddie Mac released its monthly volume summary for April last week. The firm reported a 14% annualized growth rate in the retained portfolio. While this is down from March's 17.2% growth, it is strong compared to January and February's rates of -9.9% and 2.0%, respectively. Retained portfolio growth is at 5.8% year-to-date.

Growth came on retained purchases of $29.4 billion, sales of $5.2 billion and liquidations of $15.8 billion. This compares to purchases of $30.6 billion in March, sales totaling $5.8 billion and liquidations of $14.7 billion. Net retained portfolio agreements, however, fell to $19.7 billion from $32.1 billion in March.

Within the retained portfolio, purchases of Freddie Mac securities increased $8 billion to $372.6 billion. This represents 51.5% of Freddie Mac's retained portfolio and is the highest since May 2005. Meanwhile, the non-agency portion declined $2.6 billion to $240.6 billion. Combined non-Freddie agency securities and non-agencies represent 48.5%, down from 49% in March, and down from a high of 50.1% in August and September 2005.

The total mortgage portfolio grew 6.9% in April, up from 6.1% in March, but down from January and February when growth was running at over 13%. Year-to-date growth stands at 10.1%.

Total guaranteed PC and structured securities issuance in April was similar to March, at $26.6 billion. Year-to-date issuance is at $120.3 billion. After liquidations, year-to-date net issuance totals $54 billion for an annualized growth rate of 12.1%.

Delinquencies on non-credit enhanced single-family loans continue to improve, declining to 25 basis points in March from 30 and 28 basis points, respectively, in January and February. Freddie Mac also reported its duration gap remained at zero months, and that its portfolio market value sensitive level stayed at 1%.

Mortgage application activity slows

For the week ending, mortgage application activity declined 6% overall, according to the Mortgage Bankers Association. The Refinance Index was down 4.3% to 1480.5, while the Purchase Index dropped 7.1% to 396.4. As a percentage of total application activity by dollar volume, refinancings ticked up to 37.5% from 36.6% previously. ARM share was also slightly higher at 44.3% compared to 43.6%.

Analysts from UBS noted that over the last several weeks, the Refinance Index has fluctuated in a fairly narrow 100-point range. They attribute the relatively stable Refinance Index to range-bound mortgage rates. As a result, analysts expect that if mortgage rates hold around current levels, the Refinance Index will fluctuate between the upper and lower bounds of recent experience. Factors contributing to the better than expected strength in the Refinance Index include ARM and cash-out refinancings.

Mortgage rates mixed

In Freddie Mac's latest weekly survey on mortgage rates, the GSE reported a slight increase in fixed mortgage rates, while adjustable rates recorded a slight decline.

On the fixed side, 30-year rates rose two basis points to 6.62%, and 15-year rates were up three basis points to 6.23%. Meanwhile, 5/1 hybrid rates slipped two basis points to 6.21%, and one-year ARM rates average 5.61% versus 5.62% last week.

"Currently, mortgage rates are roughly a half a percentage point higher than they were at the start of the year, which has lead to some moderation in the housing market," Freddie Mac Chief Economist Frank Nothaft said last Thursday.

This week's mortgage application activity report from the MBA for the week ending May 26 could see some impact from the approaching Memorial Day holiday. As noted above, however, refinancing activity is anticipated to remain generally range bound in the near term as mortgage rates hold in a narrow range.

Prepayment outlook

Current Street consensus estimates have speeds increasing 15% to 20% in May for 4.5% and 5% coupons, and around 10% to15% in higher coupons. The increase is due to a higher day count - 22 versus 19 - and stronger seasonals. Looking further out, speeds are seen increasing around 5% in June for 4.5% and 5% coupons, and holding steady to slower in 5.5s and above. Prepayment speeds are currently projected to decline 10% in July, due partly to a decline in collection days to 20 from 22. The May prepayment report will be released the evening of June 6 for conventional MBS and the morning of June 7 for GNMAs.

(c) 2006 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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