The rebound in the MBA Refi Index last week probably confounded some people in the mortgage market given prior expectations that prepayments were going to drop off substantially based on the back-up of rates late last year, some market observers said.
The 43% jump in refi activity to 2767 from the prior week's 1937.6 seems to indicate that the refi boom is not yet over, and the expected trail-off in refinancings may not happen yet.
In its commentary, Lehman Brothers said that the increase is a response to the continuing rally in mortgage rates. "The surge in refinancing will mean a pick-up in premium prepayments by March after a steep decline in January and February," stated Lehman.
Some sources have indicated that the considerable rise in the Index may not bode well for mortgages.
"The market's enthusiasm about falling into the mortgage sector in 2002 might be a little too ahead of itself, and the recent surge in the Refi Index should be a wake-up call that these things are highly callable instruments," said Steven Point, a fixed-income portfolio manager at Glenmede Trust Co. "They have become more callable over time, and they don't have very good convexity, so be careful where you tread."
Another concern that Point raised was if the yield curve flattens and if at some point the economy starts to pick up, banks may start opting to lend to the corporate sector as opposed to buying mortgage-backed assets. And though this might not be catastrophic for the mortgage market, with a fair amount of new supply still coming in based on continuing prepayments, there remains the question of who is going to absorb this supply.
Refi Index hike dispels link
Many mortgage players have favored the up-in-coupon trade based on the logic that at fast prepayments premium coupons earn a healthy spread to the Treasury curve.
However, Glenmede's Point said that on an absolute-yield basis, the yield is not as good as one goes up-in-coupon. On this basis, despite the fact that the lower coupons have less of a spread to the curve, they earn a much higher absolute yield.
Having said that, a lot of the dealers who continue to be proponents of mortgage-backeds coming into this year, are basing it on the assumption and the anticipation that interest-rate volatility should decline from the fairly high levels it has been recently.
But one has to couple interest-rate volatility decrease with something tangible, which would be the expectation that prepayments will become more stable and probably muted over time, stated Point.
"The rebound in the Refi Index might make people feel a little less confident about how closely they can link up a decline in interest-rate volatility with the trailing off in actual realized prepayments," said Point.
Refi activity leads to hedging
The pick-up in refinancing activity is going to affect the cuspiest coupons, said one MBS analyst, which, in turn, would affect the way people hedge their portfolios.
"The fact is that currently so much of the market is at the money - neither in the money or out of the money - so the swings in the Refi Index really change people's perception of what prepayments are going to be and therefore also affect their view on the duration of their portfolio and from there, changes how they hedge this risk," he explained.
People going in and hedging their durations actually drive buying and selling activity, said the analyst. This is why when rates back-up, there is usually a widening of swap spreads because not only are there people selling duration but there is also selling going on in the fixed side of the swaps market, which is another way to sell duration.
The surge in the Refi Index was driven by where rates were on Jan.14 and 15, when the current coupon yield had been 6.25%. But as of Thursday last week, the current coupon yield jumped to 6.45%. Analysts expect this increase to curtail this week's Refi activity.
However, because of the surge in activity that was seen recently "we are increasing our February and March speed projections a little bit," said Art Frank, director of mortgage research at Nomura Securities
There was a big rally on Jan. 10 and 11 which brought rates sharply lower. However, since that had started to reverse - mortgage rates have gotten back to where they were prior to the rally - Frank does not expect the increase in refinancings to last very long.
"What this shows is that a 6.25% current coupon can quickly revive refinancing while the 6.50% current coupon can curtail it," Frank said last Thursday. "If we freeze today's 6.45% current coupon rate, I think that speeds are going to get a lot slower. Today's rates are pretty benign for mortgages but if it goes down another 25 basis-points from today's rates, it would not be so benign for mortgages."