October was a good month for the mortgage sector. According to Lehman Brothers, the MBS Index gained 25 basis points in excess return versus Treasurys. Year-to-date, mortgages have outperformed by 86 basis points. So far, this year is turning into a "very good year" for the sector versus last year where the MBS Index underperformed by 37 basis points.

Last week, mortgages held up fairly well despite a sizeable rally that knocked the 10-year Treasury yield down to 4.57% at mid-day on Wednesday from 4.68% as of the close of Friday, Oct. 27, leading to a slight uptick in volatility. In Tuesday's session, the weaker than expected Chicago PMI and Consumer Confidence numbers rallied the market further from the previous week's gains, and on Wednesday additional gains were being made as a result of weak construction and ISM Index numbers.

The sharp rally finally brought out servicers who actively added duration, focusing primarily in FNMA 5.5s, but also in 15-year 5% coupons. There was also light, two-way flow from real money, while hedge funds were better sellers. Asia was relatively quiet, as is expected, with the higher dollar prices. There was some month end index buying; however, it was limited as the MBS Index was estimated to extend just 0.04-years on Nov. 1. Originators, meanwhile through midweek, were holding to around their $1 billion per day levels.

Yields on the 10-year Treasury are now near the recent late September lows where large banks actively sold 5% and 5.5% coupons. There is concern of that picking up now if the market holds at these levels or strengthens further. Asian resistance to the higher price levels is also expected.

Credit Suisse analysts say that bank selling is not likely to be to the same degree as seen in September - unless new lows in yields are set. Deutsche Bank added too that the combination of banks having taken the opportunity to clean up their unrealized losses, higher yields, and increased odds that Federal Reserve is done tightening should allow banks to put their accumulating deposits back to work in to the mortgage sector.

This week sees a limited economic calendar consisting of consumer credit, import prices, the trade deficit and wholesale trade. In addition, the Treasury auctions off $19 billion in three-year notes on Tuesday and $13 billion 10-year notes on Wednesday. There are several Federal Reserve officials making the rounds including FRB Chicago President Michael Moskow and FRB Cleveland President Sandra Pianalto on Monday both speaking about the economic outlook. Chairman Ben Bernanke also makes an appearance on Friday talking on the role of money in Monetary Policy.

Specifically in mortgages, Tuesday gets potential support from reinvestment of October paydowns - estimated in the low $30 billion area. The week also gets pool notification beginning on Thursday, Nov. 9, for Class A securities (30- and 20-year conventional MBS).

Analysts' sentiment last week was neutral to positive. In particular, Deutsche Bank upgraded their recommendation to a modest overweight from neutral as they see a "much more benign environment" for the mortgage sector as year-end approaches. They recommended, however, that investors scale into the sector with the ability to raise allocations in December as the sector historically has performed its best into year-end. Other factors positive for the sector include low volatility, the favorable FAS 155 ruling, and outlook for good overseas buying that could help offset some of the bank selling. UBS added that mortgages also look attractive versus other asset classes. They do believe, however, that mortgages are likely to be "highly directional, outperforming in sell-offs and underperforming in rallies."

Mortgage application

activity slides 3%

The Mortgage Bankers Association reported its Market Index declined 3% to 375.6 for the week ending Oct. 27. This came on a 1.8% slowing in the Purchase Index to 375.6 and a 4.5% drop in the Refinance Index to 1709. The Refinance Index, closely watched in MBS quarters, has slipped 13.2% since it approached 2000 in the first Wednesday in October when the 10-year Treasury yield was at 4.56%. A year ago, the Refinance Index stood at 1709.

For the month of October, the Refinance Index averaged 1779, up just 1.7% from September's average. Mortgage rates over the period were just four basis points lower on average versus September: 6.36% versus 6.40%.

Prepayment outlook

Speeds in October are expected to increase around 10% to 12% aided by an extra collection day and increased refinancing activity as a result of a more favorable mortgage rate environment in September. The October reports will be out this evening.

Looking to November, speeds are currently projected to be slightly lower with discount coupons declining around 5%, while par and premiums should be flat. December sees stronger slowing of about 7%. Both November and December are impacted by lower day counts and slowing seasonals.

(c) 2006 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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