Last week, mortgages demonstrated their current predicament. Their rich levels limited them from participating in rallies and led to strong underperformance on market selloffs. The week saw an increase in originator selling to about $1.5 billion per day - mostly in 5% coupons. In addition, there was profit-taking noted, given the near historically tight level of spreads. At the same time, there was some support on month-end extension buying early in the week, and a pickup in bank buying - especially in 15-year paper. However, many investors were waiting for cheaper entry points and for the employment report to be released.

Over the Thursday-to-Thursday period, spreads on 30-year Fannie Mae 5s through 6s were flat to one basis point tighter, while Dwarf 4.5s and 5s were two and three basis points wider.

Analysts are generally neutral to negative on the sector at this time, primarily due to their richness and near historically tight levels in spreads.

In a recent report, however, Bear Stearns says it believes the fundamentals of the market are overwhelmingly positive, despite the market volatility due to MBS hedging. The firm notes that (1) the market becomes much less prepayment-sensitive following a major refinancing event; and (2) there is a radical change in the supply-and-demand dynamic for MBS with the massive paydowns since July, which must be reinvested in a market that is facing reduced supply.

Bear predicts that the current $200 billion per month agency issuance will slow to around $80 billion per month by year end. And, of course, there is the expectation that banks will be major participants, especially with the anemic loan demand. Insurance companies have also become better buyers as a result of the increased duration in mortgages, and the steep yield curve should continue to support the CMO bid. Finally, the third point Bear highlights is the more balanced risk profile of the MBS market between call and extension.

MBS Index underperforms in September

Mortgage performance in September was disappointing after a strong start in the month. According to Lehman Brothers, the MBS Index underperformed Treasurys by six basis points and swaps by 32 basis points on a curve-adjusted basis. The sector was the worst performing of the indexes. The Agency Index returned 31 basis points versus Treasurys; ABS, 35 basis points; CMBS, 36 basis points; Corporates, 42 basis points; and the Aggregate Index returned 15 basis points in excess return.

Year-to-date, mortgages are the worst performing sector by a substantial margin at negative 74 basis points. Agencies are the next worst performers at 19 basis points in excess return versus Treasurys while Corporates are the best at 457 basis points in excess return relative to Treasurys.

By coupon, the lower coupons were the best performers with 30-year conventional 5s returning 63 basis points versus Treasurys and 30 basis points versus swaps. Meanwhile, 5.5s returned 16 basis points versus Treasurys, but were negative 10 basis points versus swaps. In 15s, 4.5% and 5% conventionals returned 42 and 13 basis points versus Treasuries, respectively, and 18 and negative seven basis points versus swaps. Higher coupons recorded negative excess returns.

Refi Index increases by 3%

The Mortgage Bankers Association (MBA) reported modest increases in mortgage applications overall for the week ending Sept. 26. While the Purchase Index declined 1% to 398, the Refi Index increased 3% to 2507. This was in line with expectations. As a percentage of total applications, refis were 53.1% versus 51.9% in the previous report. The ARM share also increased to 23.4% from 22.7%.

Freddie Mac reported the fourth straight week of declines in 30-year mortgage rates. For the week ending Oct. 3, the 30-year fixed rate mortgage rate fell to 5.77% from 5.98%. This is in line with what Citigroup Global Markets was predicting and holds rates at levels seen in late July. After holding flat in the previous report, the 15-year fixed-rate mortgage rate declined 20 basis points to 5.10%. Last, one-year ARMs reported in at 3.72% versus 3.77% previously.

With the decline in mortgage rates, JPMorgan Securities says they believe the Refi Index could top 4000 as early as next week. At current rates, Citigroup says that 45% of the mortgage universe is refinanceable and that 6% coupons are now fully refinanceable. While this is roughly half of what was refinanceable back in July, it is up about 15% from early and mid- September. Still, there is a good way to go before the next major refi event. According to Bear Stearns, the next important rate threshold comes after another 50 basis point rally that puts mortgage rates at 5.40%. This would push the massive 5.5% coupon into the refi window.

Strong slowing in September prepays expected

The September prepayment report will be released on Tuesday, Oct. 7. Consensus is calling for speeds to drop 54% to 22% CPR for 2002 Fannie Mae 5.5% coupons, and to decline from 66% to 40% CPR for 2002 6s. Further dips of 45% and 35%, respectively, are anticipated for October in these coupons. Once the next two reports are out of the way, however, the mortgage market will be in a much more stable prepayment environment, says Bear Stearns. The table shown gives the current outlook for speeds on certain coupons and vintages for both Fannie Mae and Ginnie Mae MBS.

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