Mortgage valuations remain rich as supply continues to be limited and demand holds strong. Last week, originator supply averaged about $1 billion per day. At the same time, banks were very active buyers along with insurance companies. Other investors, however, were fairly quiet.

RBS Greenwich Capital says banks are supportive as the absolute yield levels are too attractive to ignore, and because the power of a 1% Fed Funds rate makes entry points less relevant. Analysts at Greenwich also do not think that there will be a change in valuations anytime soon due to limited originator selling. JPMorgan Securities concurs, saying that mortgages should continue to perform well given the lack of supply, increasing carry, along with a modest rise in bank and insurance company demand.

Lehman Brothers, however, is concerned about the rich valuations in mortgages at this time. In last week's MBS and ABS Outlook, the firm argued that when mortgage valuations were similar to current valuations last spring, rolls were significantly better and bank demand was very strong. Now bank "demand can at best be characterized as the promise of a steady sponsorship," analysts said. In the end, mortgage valuations were not sustainable when technicals were better, so how can current valuations be justified in this environment, questions Lehman.

But, says JPMorgan, there are two critical differences between then and now. Currently, banks are "underweight" and are now likely buyers in a selloff. The firm also suggests that much of the extension "widening" has already taken place, leaving potential sellers "underweight" relative to Q2 levels. Over the Wednesday-to-Wednesday period, spreads on 30-year Fannie Mae 5s were five basis points tighter; 5.5s were in nine basis points; and 6s and 6.5s were minus 12 and 11 basis points, respectively. Dwarf 4.5s through 5.5s firmed seven through nine basis points.

Mortgage applications fall on rate gains

The Mortgage Bankers Association (MBA) reported mortgage applications fell 21% overall for the week ending Oct. 10. The Purchase Index was down 19%, while the Refi Index dropped 22% to 2340. Analysts were not expecting such a large impact on the Refi Index this soon. As a percentage of total applications, refinancings were 53.9% versus 55% in the previous report. ARM share, meanwhile, increased to 25.2% from 22.7%. Lehman expects the Refi Index to be close to 2000 in the coming weeks.

For the week ending Oct. 17, mortgage rates gained 10 basis points, according to Freddie Mac's survey. The 30-year fixed rate is now at 6.05%, the 15-year rate at 5.36%, and the one-year ARM is 3.79%. In the past two weeks, the 30-year fixed rate has gained 28 basis points, and the 15-year fixed rate is up 26 basis points.

Prepayments

expected to slow in October

The September and early-October performance in rates and the Refi Index suggests a slowing in declines in prepayment speeds. Also suggesting higher prepayment speeds than originally anticipated for October was the less-than-expected slowing in prepayments for September. At this time, consensus expectations are for Fannie Mae 2002 5.5s to prepay at 19% CPR, down 26% from September. Meanwhile, 2002 and 2001 6s are predicted to decline about 20%, to 40% and 49% CPR, respectively. Also, 2002 6.5s are anticipated to prepay at 57% CPR versus 62% last month, and 2002 7s are expected to slow to 57% CPR versus 60%. Looking ahead to November, speeds are forecast to slow about 10% for most coupons and vintages, and then increase back up to October levels in December.

As a result of current market conditions, there is still a lot of uncertainty regarding prepayments, suggests Walther Schmidt, senior vice president with FTN Financial Capital Markets. This is because a relatively moderate shift in rates has a big impact on the amount of the market that becomes refinanceable or vice versa. Currently, about 32% of the 30-year market is fully in the money, and 53% of the market is marginally refinanceable. If rates shift down 50 basis points, 53% of the market becomes fully in the money, and 83% becomes marginally in the money. A 50 basis point increase results in just 14% of the market remaining fully refinanceable and 32% marginally. "With just a 100 basis points range, either 83% or 14% of the market is subject to prepayments," says Schmidt.

During the past year, the range in the 30-year Freddie Mac survey rate has been 123 basis points, according to his analysis, and the standard deviation puts the range at over 60 basis points.

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