The drop in application activity in last week's Mortgage Bankers Association (MBA) survey - with both the refinancing and purchase indexes declining by 5% - was described by analysts as an aberration and not really meaningful.

With mortgage rates continuing to trend lower last week (Freddie Mac's Primary Mortgage Market Survey last week reported that the 30-year fixed rate fell to a new all-time low of 6.22%), nobody is really expecting the drop in application activity to continue for this week's Refinancing Index. In fact, JPMorgan researchers said they expect the Index to move into the mid-to-high 5000s in this week's results.

Refinancing and prepayment activity are obviously not about to wane. Morgan Stanley mortgage strategist Yubo Wang said that this refinancing wave is different in that prepayment risk should overshadow any supply pressure.

Supply-demand picture

"The supply-demand picture has been favorable all this year but has improved somewhat in recent weeks," said Wang last Wednesday.

On the supply front, the significant increase in paydowns has kept net issuance relatively low. For instance, net issuance in July only reached about $13 billion. Though gross supply is likely to pick up significantly, Wang expects that this would be well-absorbed by the market.

There are a number of factors driving demand, Wang said. The need to reinvest is quite large and will be absorbing some of the supply.

The GSEs are also becoming more active in their mortgage purchasing. This is made evident by the 4.6% growth in Fannie Mae's portfolio announced last week. The increase could even be considered artificial as Fannie currently has $38 billion of outstanding portfolio commitments. If these purchase commitments come to settlement in August or in September, this would mean a 5% increase to Fannie's $743.4 billion in retained portfolio holdings.

And with some pent-up demand and with mortgages cheapening, the GSEs are expected to be back in after being in retreat for a few months. Also, as the market rallies, mortgage duration has shortened relative to Agency debt.

The duration gap of Fannie's portfolio widened to -9 months at July 30 from -4 months at June 30. The shortening in mortgage duration would provide incentive to the GSEs to bring the duration to more normalized levels over time. One way to do this is to buy mortgages.

Aside from increased GSE participation, the CMO market has become quite active. So far, August activity has reached the $63 billion mark. Banks have also been aggressively adding to their mortgage holdings. Wang noted that banks have already net purchased $155 billion of mortgage-related assets this year, $137 billion of which were made over the last three months.

Prepayments gone awry

Despite positive supply-demand technicals, the current topsy-turvy prepayment scenario is still a concern. According to analysts, practically everything that people have generally considered to be discounts are now at a premium.

In last week's midweek commentary, JPMorgan said that supply should be shifting to 5.5s with 30-year 5.5s currently above par.

With so much of the mortgage market at premium prices and limited current production in the 5.5% coupon, this would limit the ability of investors to try and keep the overall dollar prices of their portfolio much closer to par or in the low hundreds dollar pricing.

"To a certain extent, investors make judgments in terms of I'm in discounts'or I'm in premiums,'" said an MBS analyst. "However, discounts have become a theoretical construct. A new loan with a 6.125% note rate would be pooled as a 30-year 5.5%. But it becomes very squirrelly, both because 5.5s are a very illiquid coupon and they are trading at or above parity."

He added that currently all the liquid coupons are above par and are prepaying fast, and anything beyond that has not yet been produced because of the rapid move downward of rates.

"You are still at a point when the market is adjusting to a shift in production from 6.5s into 6s, and yet 6s are now refinanceable," he noted. "That's weird."

The lesser of various evils

With soaring prepayment levels anticipated, it is not easy to choose mortgages on their own merits, some buysiders said.

However, for investors fearful of the corporate sector, mortgages offer a reasonable way to maintain some exposure to spread product, and still benefit if the economy does turn around and rates begin to rise.

"In that regard mortgages look pretty good," said Steven Point, fixed-income portfolio manager at Glenmede Trust Co.

But if mortgages are compared outright to bullet Agencies or Treasurys, Point noted that it is harder to make a case for mortgages when the amount of prepayment risk is considerable.

However, Point added that there is a limit to how fast speeds can escalate, and investors can actually run a lot of mortgages at pretty fast speeds and still achieve a fairly robust yield.

"It seems that history would suggest that there are some limits to prepayment activity in terms of overall CPRs," Point stated, and added that pipelines can get clogged or borrowers can decide that they do not need to rush in to do anything right away. "If you hit the 50, 60 CPR level that is probably where it caps out."

Subscribe Now

Access to a full range of industry content, analysis and expert commentary.

30-Day Free Trial

No credit card required. Access coverage of the securitization marketplace, including breaking news updated throughout the day.