Mortgages are off to a weak start this month as a flight-to-quality bid returned to the market last week.

Lehman Brothers' MBS Index underperformed Treasurys by 17 basis points in the first two days. Other indexes were also off to a negative start: ABS, negative 13 basis points; CMBS, negative 56 basis points; and U.S. credit, negative 23 basis points.

Market jitters started on Monday with news that Wachovia's CEO was ousted by its board of directors due to the effects of the subprime and credit crises.

In addition, Standard & Poor's announced that it had cut its ratings on Lehman, Merrill Lynch and Morgan Stanley. S&P said the outlook for large financial institutions in the U.S. was negative. The rating agency expects ongoing weakness in investment banking and believes there is potential for additional write-offs. The rating agency also revised its outlook to negative on Bank of America and JPMorgan Chase as well as placed Wachovia on negative watch.

The FTQ carried over into Tuesday's session with rumors circulating about Lehman - one of which was that the investment bank had accessed the Federal Reserve's Primary Dealer Lending Facility. It was subsequently denied.

There was also the Wall Street Journal story that Lehman was expected to report its first quarterly loss as a public company, and that the investment bank is considering raising between $3 billion and $4 billion in new capital. Equities felt the pressure resulting from the financial sector jitters and much-worse-than-expected monthly auto sales from the Big Three, which also added to the bid in Treasurys.

From May 30's close through June 3's close, the 10-year Treasury gained 39/32nds, the yield fell to 3.89% from 4.048%, and 2s10s steepened eight basis points to 148.2 basis points. Through midday on Wednesday, the markets were behaving more orderly because of better-than-expected economic data that helped provide a bid to equities, while Lehman was benefiting from news that investment manager Loomis Sayles has been buying the firm's debt. As a result, Merrill Lynch upgraded the stock to a buy from underperform.

Mortgage volume was running slightly below average through the first half of the week in mixed flows. Overseas was only a modest presence, but they were noted buying in the lower half of the coupon stack on Monday, only to reverse on Tuesday. Servicers were relatively quiet, while hedge funds and money managers were two-way - particularly in 5.5s.

Weakening dollar rolls were also weighing on mortgages, as were wider swap spreads and higher volatility. In other mortgage activity, 15s outperformed 30s in the first half of the week; specified pools were well bid by a variety of investors and GNMA/FNMA was little changed to slightly better because of the flight-to-quality bid. Mortgage banker selling averaged $1.5 billion per day in the first half of the week, with supply in 5.5s and 6s.

Mortgage Outlook

Analysts' tone remained favorable on the sector last week. Lehman noted that valuations were becoming more attractive from both a rate and spread standpoint and would scale into a long position if spreads continued to widen.

JPMorgan Securities analysts re-mained overweight on the mortgage/ Treasury basis as they expect swap spreads to tighten. They favor UIC and 15-years, in part on extension risk concerns.

Citigroup Global Markets analysts were recommending a partial removal of their overweight. They expect mortgage spreads will drift lower through the remainder of the year but believe the biggest influence from the GSE's additional capacity had been achieved.

Mortgage Applications Plummet

For the week ending May 30, the Mortgage Bankers Association (MBA) reported a stunning 25.7% drop in the Refinance Index to 1496.1. This is the lowest refinancing activity has been since the week ending July 28, 2006, when it was at 1417.2 and the 30-year fixed mortgage rate was at 6.72%. The MBA used just a 1/2-day adjustment rather than a full day to reflect the Memorial Day holiday. This is a factor to the particularly large decline.

Countrywide Securities analysts said that a full-day adjustment would have placed the Refinance Index in the 1700 area.

For the month of May, the Refinance Index averaged 2036, down nearly 16% from April's average of 2411. At the same time, 30-year fixed mortgage rates averaged 6.03% compared to 5.95% previously, just 8 basis points higher. This suggests that prepayments should be lower in the June report (reported in July). Currently, speeds are seen down just 1% on average.

The modest increase on average in mortgage rates in May from April versus the sharp drop in refinancings particularly shows the impact consumer confidence, home price depreciation and tighter lending standards are having on activity.

The Purchase Index was down 5.4% to 333.6 - the lowest since early 2003. Overall, mortgage application activity fell 15.3%, the lowest since the week ending April 19, 2002, said the MBA.

Contributing to the freefall was a jump in mortgage rates. The MBA said the 30-year fixed-contract rate surged 21 basis points to 6.17%. One-year ARM rates, however, were down 12 basis points to 6.80%.

As a percent of total applications, refinancing share was 40.6%, down from 46.1%. ARM share was also lower to 8.7% from 9.3%.

(c) 2008 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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