Mortgage rates continue to set new record lows with the 30-year fixed mortgage rate based on the Freddie Mac'sweekly survey dropping to below 4.40% with the no-points rate slightly over 4.50%.

While refinancing activity has been more responsive in recent weeks, successive percentage gains have been lower.

For example, for the week ending Aug. 13, the Mortgage Bankers Association's (MBA) Refinance Index surged 17% to 4677 as 30-year mortgages slipped under 4.5%, and rose 5.7% in the following week as rates declined to near 4.40%. In the most recent report, for the week ending Aug. 27, the Index gained just 2.8% to 5084, with mortgage rates in the mid-4.30% area.

It should be noted that MBS analysts had projected the Refinance Index to report around the 5500 area. While capacity constraints have somewhat lessened in recent weeks, mortgage bankers remain severely constrained.

So how high could the Refinance Index rise? JPMorgan Securities analysts estimated a maximum level of around 6000. Anish Lohokare, head of mortgage-bond strategy at BNP Paribas, said that another 10 basis point rally in primary mortgage rates could push it to the mid-6000s based on their current pace. At this point, Lohokare believes that capacity constraints would start showing up. The most recent report from the MBA suggested that it will be a struggle for the Index to hit 6000, and while there are reports that bankers are expanding capacity, it will take some time.

Prepayment Outlook

The increase in refinancing activity does portend higher prepayment speeds looming. Currently, the outlook for September and October - reported in October and November, respectively - is for speeds to hold relatively flat on average from the August report where speeds on 30-year FNMAs are projected to increase around 14%.

Slight increases are projected for 2008 and 2009 vintage 4.5s through 5s from August, with most other coupons and vintages expected to be marginally slower. For example, speeds on 2008 and 2009 4.5s are projected to prepay at 20 and at the low-30 CPR area, respectively, in September and October from 11 and 26 CPR in July; 5s at 27 and mid-30 CPRs from 19 and 29 CPR; and 5.5s in the low 20 and 30 CPRs from 16 and 28.

Factors influencing the September report include a jump of nearly 18% on average in the Refinance Index in response to a 13-basis-point decline in mortgage rates in August from July, with one less collection day partially offsetting a rise.

FTN Financial analysts expect that speeds will be faster over the next two to three months, although by then slowing seasonals will likely start to filter in.

However, borrower credit-impairment remains a strong influence and 5.5% and higher coupons will continue to have a tougher time through the refinancing process, FTN analysts noted. Meanwhile, they believe 5% coupons should see the fastest speeds on the stack given the rate incentive and their relatively high FICO scores. At this time 4.5s are just marginally refinanceable with the Federal Reserve owning a substantial portion, they added.

"Prepayment risk is not as high and uniform as it has been in past cycles of positive incentive environments, but it is not completely absent, either," FTN analysts said. "Look for the wings of the coupon stack to outperform the middle in the coming months as the market continues to come to terms with the new prepayment realities."

Supply Impact

Supply has picked up in recent weeks with days of $4 billion in mortgage banker selling occasionally being seen as refinancing activity has perked up. Still, technicals are seen as generally favorable overall for the near to intermediate term.

Barclays Capital analysts currently estimate monthly gross supply to average around $132 billion over the next year, with nearer months potentially topping $150 billion before dropping off in latter months.

Meanwhile, they projected total agency net supply over the next year to be in the negative $20 billion to negative $30 billion range.

While negative net supply should not be too much of a concern for the basis, analysts said that, "the absence of reinvestment from several large investors means the basis should be directional with rates."

For example, they specifically pointed to the Fed and U.S. Treasury Department not reinvesting their paydowns back into MBS which means private investors must absorb this supply.

Based on current rates, analysts calculated that about $320 billion per year could refinance out of the government portfolios and into the private market as new pools. If rates decline another 50 basis points, the number could jump toward $570 billion per year, or drop to $180 billion if rates rise a like amount.

Credit Suisse analysts believe private investors should be able to absorb the excess supply from the Fed given cheap valuations and attractive carry.

Money managers in particular have been underweight and are anticipated to cover their shorts over the next year, they said. In addition, they believe bank demand should continue as a result of "continued low yields and lack of alternative investments amidst a still-steep yield curve environment."

Barclays researchers also expect overseas demand picking up as a result of the attractiveness of U.S. government assets.

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