In an unprecedented move, the Mortgage Bankers Association (MBA) Refinancing Index surged last week to new heights of 6104 for the week ending Sept. 6. Before this, the previous record was 5535 - a record set last November. As a percentage of total applications, refinancing activity represented 72.5% compared to 70.9% in the previous week. ARM activity was little changed at 12.3% versus 12.4%.

With mortgage rates holding near record lows and application activity at record highs, prepayment speeds are expected to increase through October's report and hold steady in November. Currently, UBS Warburg predicts 2001 Fannie Mae 30-year 6s to prepay at 39% CPR in October, 2001 6.5s at 61% CPR, and 2001 7s at 65% CPR. This compares to 19%, 14%, and 48%, respectively, in the August report.

On a seasonally adjusted basis, the Purchase Index also jumped 12% to 402, while the Refi Index surged 19% to set the new record. On an unadjusted basis, however, applications declined with the Purchase Index down 12% to 318 and the Refi Index falling 5% to 4883. But the marginal decline is notable considering the shortened week previous.

"The actual number of mortgage applications decreased only seven percent last week compared to the previous week," noted Phil Colling, an MBA economist. "This is especially remarkable when you consider that last week included only four business days because of the Labor Day holiday."

In comments from Lehman Brothers, they note that the holiday-shortened week provides less reliable data than usual. In addition, they note an increasing disparity between their internally generated mortgage rate and the MBA's survey rate. This suggests to them that volume of application activity is straining the mortgage banker system causing originators to delay lowering their rates. As a result of all of this, they believe the Refi Index will decline in this week's results to around the mid-5000 level.

Freddie Mac reported a slight increase of three basis points in fixed mortgage rates for the week ending Sept. 13. The 30-year fixed rate mortgage rose to 6.18% from 6.15%, and the 15-year reported at 5.59% versus 5.56%. Meanwhile, one-year ARM rates declined three basis points to 4.32%.

Buyers unfazed by

increasing risks

Mortgages were back in favor last week. Good demand was seen from banks, money managers, funds, and servicers. At the same time, originator supply was relatively light at about $1 billion or so per day. As a result, spreads were tighter over the Wednesday-to-Wednesday period. Most of the tightening, however, occurred during the week of Sept. 9. Specifically, 30-year Fannie Mae 5.5s, 6s, and 6.5s were in five, eight, and nine basis points, respectively. 7% and 7.5% coupons were firmer by 16 to 21 basis points. Similar tightening was noted in the 15-year sector.

Supply remains one of three major risks in the mortgage sector. The other two are prepayment and extension. Lehman estimates net issuance to hit $50 billion per month. Deutsche Bank says they expect 15-year MBS to make up 23.4% of gross supply. This is a significant pickup from their weighting of 20.4% in the mortgage index. This has weighed on the sector resulting in cheaper levels.

While increased supply has become more worrisome, JPMorgan notes that net fixed rate supply in August was actually a negative $9 billion. Further, July reported only a $3 billion gain in net supply. Such a sharp one-month decline in issuance was not observed in last fall's refinancing wave, says JPMorgan. While they expect a significant pickup in issuance over the next couple of months, "the relatively low level may turn out to be a major positive for MBS as it implies there may not be enough fixed rate bonds to reinvest paydowns."

Despite the risks, the sector has some attractive benefits. JPMorgan upgraded their recommendation for mortgages versus agencies to overweight as the basis is at its widest level since 1998. Lehman notes that mortgage valuations look very attractive as mortgages are trading near their recent wides on an OAS basis. They are holding with neutral, however, due to the ongoing risks in the sector. Finally, UBS Warburg is holding with their modest overweight recommendation as the sector looks fairly valued on their models.

August prepayments surge

On average, speeds on Fannie Mae MBS increased about 30% in August from July. The largest percentage gains were in 6% and 6.5% coupons, of course. According to Bear Stearns, speeds on 2001 6.5s shattered all speed records for its level of refinancing incentive. Bear attributes the large percentage gains in the lower coupons, in part, to the "hybrid" effect. They note that while the refi incentive during this reporting period was a little over 50 basis points for a fixed-rate loan, it was over 150 basis points for an ARM. They believe 6% coupons will be affected by this in the next couple of reports.

Versus expectations, 2001 Fannie 6s and 6.5s were 1% to 2% CPR higher than was projected. The vintages prepaid at 18% and 38%, respectively. 2001 7s prepaid slightly lower than consensus at 47% CPR versus an expected 48% CPR; 2000 7s, however, prepaid at 61% CPR versus a projected 57%. Finally, 2000 7.5s prepaid at the consensus estimate of 60% CPR, and 2000 8s prepaid at 52% CPR versus expectations of 60% CPR.

Speeds on Ginnie Mae MBS also showed strong gains from July. In addition, speeds on unseasoned and moderately seasoned vintages in 6% through 7.5% coupons were somewhat faster than average estimates.

In other observations, speeds on 2001 7s and 2000 8s are prepaying slightly faster than conventionals, while unseasoned Ginnie 6s and 6.5s are prepaying at about 5% slower. One reason for the slower speeds versus conventionals on the lower coupons is that conventional loans are usually quicker to refinance than the government loans. As the pipeline clears out, the lower coupon Ginnies should start to catch up.

Looking ahead to the September report, further increases are expected. According to JP Morgan, the MBA's Refi Index increased by almost 50% in August. They are projecting peak speeds of 40% CPR in 6.5s originated in the fall of 2001, and 65% CPR for 6.5s originated in early 2001.

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