Mortgages were pressured last week by better selling, higher volatility, and jitters about convexity hedging. Mortgages' September performance has now dropped into negative territory, according to Lehman Brothers data. Month-to-date through Wednesday, Sept. 27, the MBS Index was down five basis points versus Treasurys.

Servicers were active last week in the mortgage market. Initial flows were down in coupon as the market rallied on Monday on the weak existing home sales report. Later in the week as the market backed up, servicers were adding duration with 5.5s and 6s. As market yields have declined below 4.60% on the 10-year Treasury, there has been increasing talk regarding convexity hedging. Analysts, however, peg around 4.30% on the 10-year for a noticeable pick-up in buying from servicers.

The decline in yields has also raised concerns about refinancing risk. While the market has rallied strongly since the end of June - around 53 basis points - said UBS analysts in recent research, the refinanceable percentages in the mortgage market remain low. UBS estimates that at this time, the no-point rate for a new 30-year conventional mortgage is about 6.33%. At this level, analysts calculate that 17.7% of the mortgage market is marginally refinanceable and only 10.8% is fully refinanceable. In dollar amounts, this is around $340 billion in total.

UBS analysts define marginally refinanceable bonds as those with a 20 basis point differential between the rate paid by the borrower and the new no-points rate. Fully refinanceable bonds carry a differential greater than or equal to 50 basis points. So at this time, mortgages with a gross WAC of >=6.53% are considered marginally refinanceable, while those with a gross WAC of >=6.83% are considered to be fully refinanceable.

UBS analysts added that if the no-points mortgage rate rallies 40 basis points to 5.93%, 34% of the market would enter into marginally refinanceable territory, while a move to 5.69% would provide 58% of the market with a refinance incentive.

Other flows of note last week included heavy selling in FNMA 5% coupons that began late Tuesday afternoon by one large seller. This brought out selling in that coupon from other real and fast money that continued into Wednesday's trading session and fueled by talk of a bank selling a large position. JPMorgan Securities analysts said that while banks may use the recent rally to move up in coupon, they do not expect banks to be net sellers of mortgages. This is primarily due to limited attractive investment alternatives.

On the originator front, it appears selling held to about its average $1 billion per day area. Supply has been focused in 6% and could shift more into 5.5s if rates remain low. Originators also have been heavily buying back some of the 6.5% originations as a result of the decline in mortgage rates.

Analyst sentiment is neutral to positive on the mortgage sector. For example, Barclays Capital analysts are holding in the neutral camp. However, they say their outlook for mortgages has improved for reasons including, the fact that the size of the rally has reduced the risk associated with sharply slower speeds and that the Federal Reserve risk appears to have faded with the outlook for a quiet Fed for the near term. At the same time, though, there is the risk of volatility continuing to move higher and convexity hedging if rates move lower.

Meanwhile, UBS analysts are still positive on mortgages, even going so far as to raise their mortgage allocation to a heavy overweight. They believe fears of a huge uptick in volatility is unwarranted, and that refinance activity will stay relatively muted at current levels. Mortgages also appear cheap on their model and seasonals for mortgages are traditionally positive heading into the final quarter. They state that between late-September and year-end, mortgages generally outperform Treasurys by eight ticks.

Refinancing activity falls

Mortgage application activity fell 5% overall for the week ending Sept. 22, according to the Mortgage Bankers Association. Despite the decline in mortgage rates during that week, the Refi Index fell 4.1% to 1677.5. Many were expecting gains in refinancing activity with the further declines in mortgages; however, Countrywide Securities did report that they had experienced a 3% slowing in their activity for that week. JPMorgan strategic principal trader David Montano said that with the slowdown in the housing market and home price appreciation, originators are probably being more cautious and requiring new appraisals, which could be slowing the refinancing process.

Meanwhile, the Purchase Index continued its steady decline to 375.9 from 397.9 previously, down 5.5%. The slowing reflects the weakness in the housing market.

30-year mortgage rate declines

According to Freddie Mac, the 30-year fixed mortgage rate dropped 9 basis points to 6.31% following a sharp rally on the weaker than expected Philly Fed and existing home sales reports. This is the lowest mortgage rates have been since March 24 when the 30-year averaged 6.32%. Mortgage rates are down 49 basis points from mid-July's high of 6.80%, and 40 basis points above levels observed a year ago, 5.91%.

"This week's economic releases, which showed a slight one-year decline in both new and existing house prices in August, fell short of market expectations and prompted market analysts to reassess how much the housing sector will contribute to economic growth in the coming year," Freddie Mac Chief Economist Frank Nothaft said. "As a result, mortgage rates declined even further this week to match those set six months ago." He added that the improving levels of mortgage rates and a moderation in home price growth should lead to increased housing affordability.

Freddie Mac also reported that 15-year mortgage rates fell 8 basis points to 5.98%. The last time the 15-year rate was below 6.0% was the same week of March 24, when it averaged 5.97%. On the adjustable side, one-year ARM rates averaged 5.47%, versus 5.54% previously, and 5/1 hybrid ARMs declined to 6.0% from 6.08%.

While the Refinance Index showed limited response to the rally in the weekending Sept. 22, there is expectation that it will show up in the release for the week ending Sept. 29. JPMorgan analysts currently predict a print in the 1850 to1900 area. If so, this would be the highest level since October of last year.

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

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