Mortgage-backed volume was running below normal in the first half of the week with flows relatively balanced. MBS spreads widened on Monday as Treasurys gave up more of their flight to quality premium. In general, overseas investors showed interest in 5.5%s and 6%s, while servicers moved into 5% coupons. Other investors such as money managers and hedge funds were better sellers. Supply was burdensome for the limited participation - totaling nearly $3 billion.

Spreads tightened on Tuesday and into Wednesday on a rather lackluster tone. Servicers and hedge funds were better buyers, particularly down in coupon, both outright and versus Treasurys and swaps, while money managers were better sellers following the recent strong gains in MBS. Supply was more manageable at just over $2 billion. Finally, performance in 15/30s, specified pools and GNMA/FNMA swaps was mixed.

Despite the favorable Federal Reserve initiatives, participants remained cautious and nimble as the news was not all good. For example, unlike the better-than-expected existing and new home sales reports for February (both declined less than expected), there were no surprises in the house price news from S&P/Case Shiller or delinquency and foreclosure information from the ABX series. The S&P/Case Shiller 20-city home price index fell 2.4% in January from December and is down 10.7% from a year ago. Prices were down in 19 of the cities with just Charlotte seeing a modest gain of 1.8% in January.

"The monthly data show that every one of the MSAs has now declined every month since September 2007, marking five consecutive months," David Blitzer, chairman of the index committee at Standard & Poor's, said. "On top of that, the declines have increased through time, in general, as 13 of the 20 MSAs reported their single largest monthly decline in January."

Year-over-year, Las Vegas, Miami and Phoenix have recorded the largest declines at negative 19.3%, negative 19.3% and negative 18.2%, respectively. The 10-city index recorded a 2.3% decline in January from December and is off 11.4% from a year ago - a new record low.

Mortgage Outlook

Street analysts' tone was mostly neutral on the MBS basis. Mortgage-backeds have rallied significantly in the past couple weeks based on all the government initiatives. In fact, month-to-date through March 25, Lehman's MBS Index is actually in positive territory - up four basis points versus Treasurys. It should be noted that in the first week of the month, the sector was down 200 basis points. In general, mortgages have been perceived as fair to somewhat rich, while spreads are not expected to tighten significantly from here.

The technicals remain a limiting factor. On the demand side of the equation, buying from the GSEs and the FHLBs probably would not be as significant as the headlines make it to be. Last week Lehman analysts projected that the reduction of the capital surcharge and potential additional capital raised could increase the amount of aggregate surplus capital to $19 billion. But given credit losses and a growing guaranty business, analysts estimated only around $4 billion of this being used for retained portfolio growth. Meanwhile, JPMorgan Securities said that under the 20% capital requirement, they do not really see an increase in the capital available to grow the retained portfolio at this time.

UBS analysts are also not expecting large-scale MBS buying by Fannie Mae or Freddie Mac. However, they believe it could reduce selling pressure. At the margin, this reduction in capital might allow for "opportunistic buying when spreads widen dramatically (cushioning the widening)," UBS analysts said.

Last Monday, the Federal Housing Finance Board temporarily increased the FHLBs' MBS investment authority to 600% of capital from 300% of capital effective immediately. This is in effect for two years. The FHFB said the expanded authority would provide more than $100 billion of additional liquidity to the MBS market. UBS analysts are not expecting a large impact from this FHFB move for reasons including the fact that FHLBs are not at their limits to begin with, the increase is limited to two years, and it's tied to capital and some of the FHLBs are concerned about potential dips in capital.

Mortgage Applications Jump

"The Federal Reserve acted last week to bring some stability to the MBS market, and we saw an immediate impact with a drop in mortgage rates," said Jay Brinkmann, MBA's vice president of research and economics. The Mortgage Bankers Association reported that the Refinance Index soared 82.2% to 4255.2 in the week ending March 21, while the Purchase Index gained 10.6% to 403.7. The last time the Refinance Index was above 4000 was for the week ending Feb. 8, when it hit 4901.5.

The MBA's survey showed another sharp decline in the 30-year fixed contract rate to 5.74% from 5.98% previously, or 24 basis points. The rate is down 63 basis points since the week ending March 7 and is at its lowest since 5.72% for the week ending Feb. 8. The one-year ARM rate rose three basis points to 7.02% and is up 30 basis points since March 7.

As a percent of total applications, refinancings jumped to 62% from 49.7%. ARM share dropped to 3.8% from 7.9%.

Prepayment Outlook

Prior to the February prepayment news, Street consensus was calling for speeds to increase about 13% in March. Following a larger-than-expected increase in speeds in February, partly in response to a rush of closings before the March 1 GSE fee increases, prepayments are now expected to be 5% lower on average on 4.5s through 6.5s.

The largest percentage of declines is expected in 2006 vintages as well as 5% and 5.5% coupons. Contributing to the slowing are higher mortgage rates in February versus January - averaging 5.92% versus 5.76% - while the MBA's Refinance Index averaged 12% lower in February versus January.

Looking to current projections for April and May, prepayment speeds are expected to slow around 7% to 10% and by about 5%, respectively. However, upward revisions to these outlooks seem likely with the sharp drop in mortgage rates over the past two weeks. The mortgage rate dip happened as the sector rallied based on the latest Fed programs to improve liquidity combined with the pickup in refinancing activity.

(c) 2008 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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