Last week was a wild one in mortgage-backeds, as the fixed income markets were held hostage to equities. Over the Wednesday-to-Wednesday period, the 10-year Treasury yield dropped nearly 30 basis points to around 4.42% as of mid-day Thursday. With the strong flight to quality bid, mortgages lagged with spreads widening about 16 basis points on average versus benchmarks.

There was strong buying on the weakening, especially from hedge funds and servicers. Banks were better sellers early in the week on profit taking, in part to buy back equity; and CMO dealers were active, particularly in 15-year 5.5s. Many investors, however, are becoming increasingly premium resistant with the average mortgage price at over $103.

Originator selling started the week off at the $500 million level, but steadily increased to nearly $2 billion by Thursday. With rates so low, total U.S. mortgage origination for the first half of the year jumped 79% to $631.1 billion, according to Lehman Brothers. The firm says its forecast calls for a reduction in mortgage origination to $1 trillion this year which would be the second best on record behind 2001's $1.1 trillion. This may get revised if mortgage rates continue to move lower.

Street sentiment regarding the sector is generally neutral. Concerns are increasing regarding supply, convexity, and increased volatility. On the flip side, however, hedge funds are expected to be supportive until the equity situation improves. Additionally, investors are underweight the sector, according to JPMorgan Securities' latest MBS Client Survey which suggests investors have room to add mortgages as spread widening opportunities present themselves. In JPMorgan's survey, the share of overweights plunged to 14.7%, an all-time low, from 39.7% two weeks ago. At the same time, the share of underweights jumped 20% to 44.1%, equal to its all-time high. JPMorgan attributes the change in sentiment to premium resistance with the average mortgage price at about 103-16. In addition, there is concern about supply as mortgage rates drop bringing the 6.5% coupon closer to a refi opportunity.

Mortgage Indexes

The Mortgage Bankers Association's Refi Index finally responded to the sharp decline in mortgage rates over the past several weeks. For the week ending July 19, the Refi Index surged 29% to 3512. Since mortgage rates peaked at 7.18% at the end of March, 30-year mortgage rates are down 84 basis points, and the Refi Index is up 189%. UBS Warburg says it is forecasting agency supply at $99 billion by quarter-end.

As a percentage of total applications, refinancing applications jumped to 61.2% from 53.4% in the previous report. The last time the share of refi applications exceeded 60% was the first week in December 2001 says the MBA. Also of note, the share of ARM activity rose to 18.5% from 18.0%. Phil Colling, an MBA economist, said that "at the current record low mortgage rates, it is possible that some people who had refinanced earlier at a higher rate are now refinancing again."

The Purchase Index fell 7% to a still strong 351.

Freddie Mac reported on Thursday that 30-year mortgage rates set a new low, beating last November's 6.45% rate by 11 basis points. For the week ending July 26, the 30-year fixed rate mortgage rate fell 15 basis points from the previous week to 6.34%; the 15-year fixed rate plunged 17 basis points to 5.76%; and the one-year ARM rate is at 4.31% from 4.50%. Based on the lower rates, further gains are expected in this week's Refi Index. At this time, Credit Suisse First Boston sees a mid-4000 reading.

In a report released in June, Bear Stearns stated that a critical prepayment threshold will be reached when a majority of borrowers are able to secure no-point 30-year financing at a mortgage rate between 6.50% and 6.55%. At this level, according to Bear, 2001 conventional 6.5s will be refinanceable. There are $289 billion of these pools outstanding, representing 19% of all conventional 30-year paper in this single coupon. Further, says Bear, with the addition of 2002 paper, the total increases to $381 billion, 25% of all conventional 30-year paper.

Prepayment outlook

On the strong drop in mortgage rates, UBS Warburg upgraded their prepayment expectations this week. They now predict 2001 6s to prepay at 20% CPR by September compared to a previous estimate of 14% CPR. In June the coupon recorded a speed of 9% CPR. Speeds on 2001 6.5s have been increased by 11% CPR to 35% CPR. In June, the coupon prepaid at 15% CPR. 2001 7s are now predicted to prepay at 49% versus a previous prediction of 38%. June's speed was 28% CPR. Finally, 2001 7.5 speeds have been increased by 9% CPR to 54% CPR. 7.5s prepaid at 39% in the last report.

Lehman has also substantially upgraded its prepayment forecasts. The firm is now predicting a peak speed of 28%, 46% and 52% CPR for 2001 6s, 6.5s and 7s, respectively. 2000 7.5s are forecast to peak at 66% CPR.

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