The sharp rate backup has changed the mortgage market from one in which almost all mortgages were refinanceable to one in which fewer than half are refinanceable. In this scenario, investors are asking how slow can speeds get if rates hold.

According to Bear Stearns, the record origination volumes will ultimately not delay any slowing in speeds as originators try to clear their extensive pipelines. In a report, the bank said most of the declines would happen in the next three months, as capacity issues have increased the lag between application and prepayments only by several weeks. This is why originators should clear any backlog in their pipelines relatively quickly, Bear said, with prepayments reflecting this even during the next three months.

UBS Warburg concurred that speeds would be slowing fairly quickly. To back up their point, analysts at UBS in a report cited historical experience and the increased efficiency of the refinancing process.

The ARM effect

However, other analysts believe that even with higher rates, relatively healthy refinance activity will remain, propped up by robust refinancing into ARMs.

In a recent report, Countrywide Securities said that the proportion of the fixed-rate mortgage market that eventually refinance into ARMs, coupled with the state of the housing market, will bolster baseline speeds for at- and out-of the money MBS.

Countrywide said there are various factors that influence a borrower's decision to go into an ARM, such as how much "reset risk" borrowers are willing to take for a given reduction in their payments, and how long they expect to stay in the property. Another factor mentioned: the issue of points willing to be paid by the borrower.

The firm added that a major question for investors would have to do with the terminal speeds for coupons such as 30-year 5.5s, which are now out of the money by 20 to 40 basis points. Countrywide said that the two issues that would influence how fast this sector would prepay are fixed-to-ARM prepayments, along with the state of the real estate market and its impact on housing turnover and cashout activity. The report said that the ARM component of the equation suggests that prepayments speeds on coupons such as 5.5s, which seem to be fully out of the money, may not "come to a crashing halt this fall."

"While we look for a sharp slowdown, we think it is reasonable to conclude that 5.5s may prepay faster than they have in similar circumstances," Countrywide said in the report.

Investors still like MBS

Meanwhile, investors remain sanguine on the mortgage market. Pete Perrotti, senior vice president and director of MBS at Hartford Investment Management Co., said that he likes the mortgage market at this juncture based on fundamentals as the carry on mortgages is positive right now. However, the technical situation is not as rosy since demand from banks and the GSEs appears to have dipped.

Though Perrotti expects a significant slowdown in prepayments, the exact timing is still in question. It would be hard to estimate how slow the October print would be, for instance. However, November and December prepay speeds are expected to be much slower. He also explained that Hartford likes 6s at this point because this sector should still provide some insulation from further rate backup.

Other buysiders say that the slowing in refinancings would probably lift the yield on higher coupon mortgages, despite the fact that the yield curve remains fairly steep. As mortgage investors extend out the yield curve, they would have to compete against fairly large increases in yield in the Treasury and corporate markets. This would mean that investors should move into coupons where, if the security extends, they could still earn a reasonable amount of yield.

"It looks like there has been an improved bid in the higher coupons as was reflected in the financing rates available in the dollar roll market," said Steve Point, a fixed-income portfolio manager at Glenmede Trust Co. "Even though last month was a surprisingly fast prepayment month, everything is pointing to refinancings slowing down in the next couple of months."

Point added that even with the expected slowdown, loans that are out of the money could still provide some relative value as they might not slow down as drastically as expected. This is because the borrowers who have just refinanced could still get a purchase mortgage since they might want to change houses for other reasons, such as upgrading into a more expensive house or moving with a new job. Purchase-money mortgages tend to have longer durations compared to refinance loans.

Because of the existing incentive of borrowers to move into purchase mortgages, Point said, "There is probably more embedded turnover in the market right now even though some loans look like fairly new production."

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