Mortgage flows have been at the mercy of Treasury market performance. Last week, the sector was mostly hit by supply, increased investor selling and limited buying as the market traded south. The one exception was mid-week when Treasurys stabilized and held higher throughout the session. This encouraged investors to take advantage of the recent widening in spreads.

Over the Wednesday-to-Wednesday period, spreads on 30-year Fannie Mae 5s were one basis point tighter, while 5.5s and 6s were wider by 10 and seven basis points, respectively. The trend was similar in Dwarfs with 4.5s also one basis point tighter over the week, while 5s and 5.5s were plus eight and seven basis points.

According to a Bear Stearns report, refinancing exposure has fallen to 59% from 96% as a result of the backup. In dollar terms, this is $1.6 trillion of current exposure versus $2.7 trillion one month ago. At less than 60%, Lehman Brothers says the market is at high convexity risk, which could put significant pressure on the market. Bear Stearns calculates that market duration extends by about a half-year for every 25 basis point move higher in rates. In terms of 10-year equivalents, a 25 basis point move results in an additional $172 billion to $968 billion. A 50 basis point move results in a $317 billion change from current levels to $1.1 billion in 10-year equivalents.

Despite the risks, analysts are mostly favorable on the sector with overweight recommendations. However, they are not encouraging an increase in those overweights. In comments from UBS Warburg, they note that while mortgages have cheapened, they are not cheap enough to justify a full overweight, especially as they expect banks to buy less and servicers to lighten up on their hedges as rates rise.

Mortgage applications decline

The Mortgage Bankers Association (MBA) reported declines in mortgage applications for the week ending July 18. The declines, however, were less than expected. Countrywide Securities suggests this may be due to marketing campaigns from large originators, as well as some fixed-to-ARM refinancings.

Specifically, the Purchase Index fell just 1% to 442 while the Refinancing Index declined 7% to 6181. By type, conventional refis fell 8% to 6737. However, government refis rose 1.5% to 3263. Citigroup has noted the recent performance of the government index versus the conventional index over the past couple of months and says that Ginnie Mae speeds may experience larger increases compared to conventionals in July as a result. In fact, consensus has speeds on Ginnie 2002 5.5s jumping 33% versus 27% for Fannies, and 2002 6s rising 19% versus 14%.

The MBA also reported that as a percent of total applications, refis fell to 68.7% from 70.1%. At the same time, ARM share rose to 16.7% from 15.4%.

Fixed-rate mortgage rates jump

Freddie Mac reported substantial gains in fixed-rate mortgage rates for the week ending July 25. The 30-year fixed-rate mortgage rate surged to 5.94% from 5.67% and the 15-year fixed-rate mortgage rate increased to 5.27% from 5.00%. At the same time, the one-year ARM rate increased nine basis points to 3.67% from 3.58%.

JPMorgan Securities said it expects the Refi Index to stabilize in the low 5000 area at current rates. In addition, the increase in fixed rates should continue to encourage fixed-to-ARM refinancings, which in turn, increases the ARM share of applications. This, of course, should continue keeping net fixed rate supply flat to negative.

Prepayments drop in September and October

The increase in mortgage rates is expected to primarily impact the September and October reports. Bear Stearns is predicting that after increasing to 55% CPR in July, 2002 Fannie 5.5s will slow to 36% CPR by September and 19% CPR by October. It forecasts 2002 vintage 6s to hit 71% CPR this month, and fall to 55% CPR in September and 44% CPR by October.

The accompanying table gives the current consensus outlook on 30-year Fannie Mae and Ginnie Mae MBS.

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