After a stellar 2006, mortgages are off to a strong start in 2007. According to Lehman Brothers, the MBS Index outperformed Treasurys by 122 basis points in 2006 compared with negative 37 basis points in 2005. The sector also performed well versus ABS and CMBS, which provided excess returns of 87 and 137 basis points, respectively, last year. So far in 2007, the MBS Index is up 15 basis points compared with two and four basis points over Treasurys for ABS and CMBS.

Contributing to the gains has been active buying that was stimulated by the end-of-year sell off that moved the 10-year Treasury yield from 4.623% on the Friday before Christmas to 4.708% on the last day of trading for the year. Fast money has been a strong buyer, taking advantage of the Asian holidays to add on expectations of strong buying when Asian investors return. Servicers have also been active, focusing particularly on 5% coupons. Real money, including banks, has been a brisk investor at these higher levels, interested mostly in 5.5s. Meanwhile, Asian buyers were relatively quiet as the region had extended New Year's holidays.

Originator selling picked up as the week progressed, averaging slightly over $1 billion per day. Supply was concentrated in 5.5s.

Analyst sentiment as the year gets started is positive for mortgages. For example, UBS analysts continued to recommend an overweight to passthroughs. However, they said that they would scale back to neutral on further strong performance.

JPMorgan Securities analysts remain positive on the basis despite the strong performance in the past couple of months. Specifically, they noted the supportive factors of reduced refinancing risk in 5.5s on the year-end sell off, expectations of further declines in volatility, as well as strong foreign investor sponsorship. JPMorgan analysts favor the up- in- coupon trade as they believe interest will be around the par-priced mortgage. In addition, carry favors higher coupons.

Near term events this week are also typically supportive for mortgages. December prepayment reports were released last Friday. Before this, JPMorgan estimated that paydowns would total around $33 billion, down from $36 billion in November. Tuesday begins 48-hour notification for Class A securities (30-year conventionals), and on Friday for Class B securities (15-year MBS). There are several economic releases scheduled, including international trade and wholesale inventory and sales on Wednesday, and retail sales on Friday. Friday also sees a short trading session, ahead of a full market close on Monday, Jan. 15 for Martin Luther King Day.

Mortgage application

activity increases

Not unexpectedly, mortgage application activity rose slightly for the week ended Dec. 29 following two weeks of declines as borrowers' focus turned to the holidays. According to the Mortgage Bankers Association, the Refinance Index was up 2.2% to 1640.4 from 1604.6, and the Purchase Index gained 4.3% to 406.9 from 390.2. A year ago the Refinance and Purchase Indexes stood at 1363 and 418, respectively.

As a percentage of total application activity, refinancings were 48.1%, down slightly from 48.8% in the previous report. ARM share was also lower at 20.4% compared with 23.1%.

30-year mortgage rate

holds unchanged

Fixed mortgage rates were little changed from the previous week, according to Freddie Mac's weekly survey. The 30-year fixed mortgage rate was unchanged at 6.18%. Mortgage rates are down just slightly from last year's level of 6.21%. Meanwhile, 15-year fixed mortgage rates averaged 5.94%, a basis point higher than the previous week. In the adjustable programs, five-year hybrids rose four basis points to 6.02%, while one-year ARM rates declined five basis points to 5.42%. Mortgage application activity is expected to have started to recover in the first week of the new year from its holiday slowdown.

"Interest rates were flat this past week, reflecting the mixed messages from recent economic indicators," Frank Nothaft, Freddie Mac chief economist, said. He added that the recently released manufacturing report improved, and although construction spending for November was down, it was still better than expected. But on the downside, Nothaft said that a private sector employment report showed that the labor market is weaker than what it is generally believed to be. "Currently, the market is waiting for a clearer signal on the direction in which the economy is heading," he said, noting that this clarity could have come with last Friday's employment report.

Prepayment outlook

Speeds in December are predicted to slow less than 5% overall in FNMAs with discounts showing larger percentage declines of 6% on average, and premiums smaller declines of around 2%. Speeds on GNMAs are expected to slow around 2% to 3% for most coupons and vintages.

Factors influencing the report include slowing seasonals. However, this is partially offset by a more favorable mortgage rate environment. The 30-year fixed mortgage rates averaged 6.24% in November, down 12 basis points from October's average, while the Refinance Index averaged nearly 8% higher.

In a report released last week, UBS analysts said that 2006 passed without any major prepayment events. After reaching its peak of 6.93 in the week of July 20, the Freddie Mac 30-year no-point survey rate rallied 65 basis points, ending the year at 6.28 [6.18 + 0.4 points]. They said that the lack of refinance response to such a rally thus far could signal some things to come in 2007. In short, analysts expect the combined effect of these three factors -housing market downturn, weak media effect, and flat curve - to overwhelm any minor rate rallies. From the current rate level, they said that it would take at least 45 basis points to rekindle any significant refinance waves.

(c) 2007 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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