In a week that was called "violent" by some analysts, refinancing risk has once again reared its ugly head. Last week's rally has altered the prepayment and supply outlook for the sector by placing primary mortgage rates within 25 basis points of their historical lows - creating similar incentives for homeowners to refinance as those seen at the height of the 2003 prepayment wave.

In a report released last Tuesday, Morgan Stanley said Monday's rally brought par-coupon yields to 4.80%, which is just 16 basis points more than the peak prepayment rates in July and August of last year. Compounding this is the mortgage origination spread (which is the difference between the effective zero-point rate to the borrower and par-coupon yields) has tightened by roughly 10 basis points since then, prompted by falling originations.

"Roughly speaking then, homeowners can refinance at the same rates as those that triggered the peak prepayments last year," wrote analysts from the firm. They noted that during this period last year, 6s and higher coupons prepaid above 70% CPR, and monthly supply of conventional fixed-rate collateral was more than $180 billion.

However, analysts are not too concerned because the mortgage market today is quite different than it was last year. For one thing, since the summer of 2003, prepayments have shifted the coupon stack toward the slower 5s and 5.5s and away from the faster prepaying 6.5s and 7s. "This restriking of the mortgage universe towards lower coupons by itself would lower the average prepayment rate on the 30-year conventional universe by about 8% CPR (from the peak 57% CPR rate last summer)," Morgan Stanley analysts said.

Aside from this, many of the borrowers who were eligible to refinance have already done so. Analysts expect considerably slower prepayments on premiums versus last summer's peak. The 30-year conventional universe is predicted to prepay at an average of 37% CPR versus 57% CPR seen in the summer of 2003.

In terms of supply, going forward MBS supply should average about 65% of the peak levels last summer when conventional 30-year issuance peaked at $110 billion and 15-year issuance reached its height at $60 billion, analysts at Morgan Stanley said.

Refi Index as an indicator

Expectations for the Mortgage Bankers Association Refinancing Index support the view that the market will not see a repeat of last summer's frantic prepayments.

Art Frank, head of mortgage research at Nomura Securities International, anticipates the Refi Index to reach the high 4000s this coming Wednesday, though he does not think that there is any possibility of it going back to the 9000 level seen last June. This is partly because rates are not as low as last summer and partly because the universe of refinanceable mortgages is smaller now then it was then. However, he has accelerated his prepayment projections since last week's rally was still significant.

For instance, 2002 5.5s came in at 22% CPR in February. He predicts that this cohort is going to prepay at 29% CPR in March, 35% CPR in April and 39% CPR in May. In other words, prepays will likely increase by 75% in the next three months.

However, though March speeds are already determined, prepayments for April and May will still depend on interest rate changes. If rates back up from here, the accelerated prepay projections may be modified downward. Frank said that the prepayment report for March (coming out in April) would be less influenced by what happens in the remainder of March because people who file their applications in late March probably won't complete their refinancing until May.

Frank believes that 5.5s are the most vulnerable because they have not yet been subject to heavy refinancing. He added that it would be awhile yet before 5s become refinanceable; also, 6s are still moving from being "somewhat refinanceable" to "fully refinanceable."

Frank said that the 6% coupon got beaten down pretty badly last week and has actually gone down in price as Treasurys rallied. Pricing for 6s peaked on Monday and fell four ticks each on Tuesday and Wednesday of last week, due to refinancing concerns. With its price at over 104, the refi worries surrounding the coupon caused significant selling last week.

In a related report, UBS said that with the no-point mortgage rate at roughly 5.60%, and all mortgages with rates of 5.80% and over marginally refinanceable, the portion of the total universe that is marginally refinanceable is 74.6%, while the percentage of the 30-year Fannie Mae universe that is fully refinanceable is 43.5%.

Before the recent rally, the no-point rate has been in the area of 5.80%. This has put the marginally reinanceable percentage at 45% to 50%, and the fully refinanceable percentage at roughly 40%.

Putting this in a historical perspective, at the height of the refinancing last June, 99% of the market was at least marginally refinanceable and 94% was fully refinanceable. So the current number of refinanceable mortgages is still considerably lower than the peak seen last June.

Aside from this, even if no-points mortgage rates were to go back to June lows, only 80.5% of the mortgage market will be even marginally refinanceable while 71.5% will be fully refinanceable. These numbers are significantly less compared to those seen in June of last year. The considerable reduction reflects the reshaping of the mortgage market.

An investor's


Bill Chepolis, portfolio manager from Deutsche Asset Management, thought the market was fairly orderly after the Treasury rally. "I don't think that people were that far out of position," he said.

Despite talk of Fannie Mae adjusting some of their positions with swaps and originators and servicers doing some adjusting - such as moving down in coupon - most investors were neither panicked nor were they pushed into doing things that they wouldn't normally do.

Convexity hedging needs are not as significant as they were in July. However, another 15 to 20 basis point rate drop from current levels is bound to be problematic.

"I think that people are pretty well hedged down to [the] 3.85 to 3.92 range on the 10-year," Chepolis stated. The market is

well positioned because investors have continued to come in and buy over time, and not invest on sudden rate drops.

As for Deutsche, the firm is slightly long duration in mortgages but not excessively so. This is because Deutsche runs mortgage funds and mortgages trade to a much shorter duration on the way down. The firm has moved down in coupon in the past month or so. Deutsche has moved out of 6s (where prepays are currently quite fast), and it has also moved out of 5.5s down into 5s. While Deutsche hasn't bought many 4.5s, servicers probably made this purchase, as they view 4.5s as having the most duration.

Deutsche also has a 5% weighting in Treasurys. Though this is not a significant underweight in mortgages, the firm is a little nervous about what happens to mortgages as rates fall.

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