At current market levels, mortgages have hit what Deutsche Bank Securities analysts call an "inflection." In other words, further rallies will hurt MBS. At this point, analysts are mostly neutral on the mortgage sector with preference holding for current coupons.

The technical situation in the mortgage sector remains positive due to reinvestment of heavy paydowns and limited originator selling. Further support is expected to come from bank portfolios. According to Lehman Brothers, banks have been less active lately, but with prepayments and deposit growth, they expect banks "to come back with a vengeance."

Originator selling last week averaged about $2 billion per day - the high end of the recent normal range. The selling consisted primarily of 30-year 5s, but mortgage bankers have started bringing 30-year 4.5% coupons.

Over the Wednesday-to-Wednesday period, spreads were tighter with the 30-year 5.5% coupon outperforming due to roll-related activity. Meanwhile, 30-year 5% Fannie Mae MBS were three basis points tighter while 5.5s were moved in 13 basis points. Also, 30-year Ginnie Maes saw good sponsorship last week and outperformed Fannies. Additionally, 5s were five basis points firmer, and 5.5s were minus 15 basis points. Finally, Freddie Macs lagged due to the negative press headlined by the dismissal of top brass at the GSE, and announcements of investigations by the SEC and the House Financial Services Committee. The 5% coupons were one basis point weaker, while 5.5s were nine basis points tighter. Lastly, dwarf 4.5s and 5s were two and four basis points firmer, respectively.

According to Lehman, the MBS Index put in its worst monthly performance in May since November 2001. Mortgages underperformed Treasurys by 29 basis points and swaps by 28 basis points. By coupon, the worse performers were 30-year 6s and 6.5s losing 50 and 25 basis points, respectively, versus swaps. The best performing coupon was 5s providing excess return of 14 basis points while 5.5s returned five basis points. Returns in the 15-year sector were all negative. Meanwhile, 4.5s returned (11 basis points versus swaps); 5s (26 basis points); and 5.5s (57 basis points). The dominance of premiums in the index contributed toward the sector's

poor performance.

Mortgage Indexes decline despite record low rates

For the week ending June 6, the Mortgage Bankers Association (MBA) reported a 9% decline in both the Purchase and Refi Indexes. The Purchase Index fell to 419 from 461, and the Refi Index dropped to 9047 from 9978. The slowing was not unexpected as last week's number was adjusted by one day to account for the Memorial Day holiday. Citigroup analysts believe this adjustment may have been too strong. They also suggest another reason for the decline may have been tied to some borrowers waiting on expectations of even lower rates in the near future. Lehman analysts add that investors should not read too much into the slowing since the average level of the Refi Index for the past three weeks has been 9300.

On an unadjusted basis, the Purchase Index rose less than 1% while the Refi Index increased 13%.

As a percent of total mortgage applications, refinancings rose to 76.9% from 76.7%. The ARM share increased as well to 14.0% from 13.1%.

Mortgage rates set another new record low

Freddie Mac reported that mortgage rates set another new record low for the week ending June 13. The 30-year fixed rate mortgage rate fell five basis points to 5.21%; the 15-year fixed rate mortgage rate was down six basis points to 4.60%; and the one-year ARM reported in at 3.54% versus 3.59% last week.

Current rate levels should hold the Refi Index above the 9000 mark over the next few weeks. Regarding prepayment speeds, analysts are anticipating a dramatic increase in June and further gains in July. At this time, Lehman anticipates speeds on 2002 5.5s will prepay at more than 50% CPR in July, and 6s at over 70% CPR.

May prepayments decline

May prepayment speeds declined modestly on conventional passthroughs. Consensus was predicting speeds to hold flat. However, as suggested by JPMorgan Securities, the sharp drop in mortgage rates over the past two months encouraged borrowers to walk away from rate locks and delay closings to early summer. Lehman also noted some slowing was likely due to a lower day count.

Speeds on 2002 Fannie 5.5s declined 6% to 18% CPR and 2002 6s fell 8% to 45.5% CPR. Higher coupons recorded less of a decline while older vintages increased slightly. Freddie speeds experienced larger declines in currents than Fannies. For example, 2002 5.5s dropped 13% to 22% CPR and 2002 6s fell 12% to 48% CPR.

Total paydowns on 30-year conventional mortgages totaled $89 billion in May, according to Lehman. This is down 12% from April as speeds slowed.

Ginnie Mae speeds, on the other hand, were slightly higher in unseasoned to moderately seasoned 5s through 6s. Higher coupons and older vintages were essentially flat to slower.

At current mortgage rate levels, 95% of the market is exposed to a refinancing incentive, says Bear Stearns.

This totals $2.73 trillion. In addition, says Bear, the average borrower now has a record refi incentive of 142 basis points into a 30-year mortgage.

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