Mortgage-buying flows continued late into last week, taking a turn for the better following Thursday's $6 billion 10-year Treasury auction announcement. Thirty-year current coupons have been particularly well-bid and boosted basis gains, sources say, while 15s continue to see good buying interest as well and posting similar gains.

Spreads, which had been three basis points cheaper, were closing the week two to three basis points tighter due to the strong buying interest. Conventionals had the slight advantage over Ginnies, but lower coupons, up through 7s, were all tighter last week.

Aside from pass-through interest, there continued to be a good bid for CMO paper by money managers, as discount coupon issues were especially sought after. The recent rate backup is prompting a quick value-buying play, but extension risk continues to be an issue, as does supply. Waiting it out is the hardest part.

The decline in rates throughout the summer is expected to offset some of the effects of the lower day count seen this month, analysts said. The September report is the tip of the iceberg, though strong gains are expected in October with peaks seen hitting in November.

Freddie Mac announced the results of its most recent weekly mortgage rate survey and as expected, rates declined several basis points. The 30-year fixed-rate mortgage rate dropped eight basis points to 6.64%, the 15-year rate plunged 12 basis points to 6.11%, and the one-year ARM rate declined to 5.34% from 5.45%. The drop in rates to levels last seen in 1998 support expectations of strong gains in next week's MBA Refi Index. It also suggests that peak speeds may be extending into December.

With the curve so steep, UBS Warburg advocates selling ARMs and buying either pass-throughs or short jumbo sequentials. The reason is that ARMs are rich, and the base yield pick up is enormous.

To illustrate, UBS uses a Ginnie 4.5% yielding 5.53%, a 3/1 ARM yielding 5.84%, and a 5/1 hybrid yielding 5.87%. This compares to a 6.05% yield for a FNCL 6.5%, and 5.97% for WFMBS 2001-21 A4, a short jumbo sequential.

Versus the pass-through option, the results do not count its additional liquidity in the pass-through or the possibility of favorable dollar rolls. Also, the MBS market looks more attractive under a wide range of interest rate scenarios. The short sequential out-yields the Ginnie II 4.5% ARM under every scenario illustrated, and is mixed when compared to the hybrid ARMs.

In addition to the attractive pick up, UBS warns that with the curve so steep, ARM production is likely to increase substantially and put pressure on ARM prices. It is expected that ARMs will go from 4.2% of total agency production to 7-8% of total agency production.

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