Last week was another rough one for mortgages. The outlook at the start of the week seemed very favorable following the employment report rally with the 10-year back in its range - though at the high end. In fact, Monday saw good buying from real money investors, particularly 5s and 5.5s, on the improved fundamentals, ongoing favorable technicals and lower vol.
Tuesday and Wednesday, however, were a very different story. Active selling hit the mortgage sector as the 10-year backed up to over 4.50% by Wednesday's close. There was strong selling from originators and servicers as well as fast money. Better selling was seen in lower coupons, while there was some limited up in coupon movement reported as the curve steepened.
The sell-off that began Tuesday was attributed to a number of things including the upcoming five- and 10-year auctions, corporate hedging, leverage players and mortgage accounts shedding duration. Volatility spiked up on the sell-off, and according to RBC Dain Rauscher's Senior Mortgage Strategist Kevin Jackson, Tuesday was the largest single day rise since May of last year.
The recent sell-offs are bringing extension risk back into focus. RBC's Jackson said that in 1994, speeds on certain pools came to a screeching halt and in some cases paid at less than 100 PSA for a couple of years. He suggests investors look at pools that are backed by California and New England loans, whole loan paper, and 10-year 5s and 5.5s as a way to reduce this risk.
Once the market stabilizes and risk of servicer selling is reduced, it is anticipated that investors will take advantage of the widening. In early trading on Thursday, relative value investors were starting to dip their toes in the water as the market responded favorably to the initial claims report and additional servicer selling failed to appear. In comments from JPMorgan Securities, however, analysts believe "mortgages are likely to continue to perform poorly this month. Rate levels do not appear stable with limited real money buying for quarter end." JPMorgan does anticipate activity for April. For now, researchers recommend a tactical underweight with the possibility of adding near the end of the month.
Application activity holds steady overall
Mortgage application activity was down just slightly as a gain in purchase activity partially offset a modest decline in refi activity. The Mortgage Bankers Association reported that the seasonally adjusted Purchase Index rose nearly 3% to 452 for the week ending March 4 - its highest point of the year - while the Refi Index declined almost 5% to 2177. On an unadjusted basis, the Refi Index rose 6% while the Purchase Index jumped around 16%. As a percentage of total application activity, refinancings were 42.6%, versus 44.8% in the previous report. ARM share was little changed at 30.5% versus 30.7%.
No surprise that mortgage rates are higher
Freddie Mac reported modest increases in mortgage rates for the week ending March 11. The 30-year fixed-rate mortgage rate increased six basis points to 5.85%, and the 15-year fixed rate mortgage rate was up five basis points to 5.38%. Freddie Mac's Deputy Chief Economist Amy Crews Cutts noted that "even with rising rates over the last four weeks, 30-year fixed-rate mortgage rates remain an historical bargain. To date, contract rates for these mortgages have been below 6% for 31 weeks in a row, and we don't expect these rates will rise very much above 6.25% by year end."
Freddie Mac also reported that the 5/1 hybrid ARM rate increased to 5.22% from 5.17%, while the one-year ARM rate jumped 10 basis points to 4.24%.
In comments last week from Bear Stearns, analysts noted that with the 30-year mortgage rate back above 5.80% and the curve much flatter since the start of the year, they expect the Refi Index will retreat back towards the 1700 area. In the near term, this week's Refi Index is expected to decline towards 2000.
February prepayments faster than expected
February prepayments were slightly faster than consensus expected for FNMA 4.5s through 5.5s. Speeds on these coupons increased about 10% to 20% versus expectations of only a slight change, and Golds speeds were even greater at about 15% to 30% - though speeds continue to lag FNMAs. GNMA speeds were also higher than anticipated for consensus, particularly the premium coupons. Like conventionals, speeds on GNMAs were anticipated to hold steady.
JPMorgan attributed the increase to lags noting that six-week lags implied a decline while a five-week lag implied a pickup of around 2% and a shorter lag implied a 10% pickup. Lehman Brothers noted that the increase in February came on only mildly higher application activity and just one-day shorter business calendar. As a result, they believe that a higher than expected fall in prepayments in January was a reflection of lower "actual" January day-count which in turn would explain the bigger increase in February prepayments.
Speeds in March are expected to pick up sharply - around 30% or more. Speeds will be affected by the decline in mortgage rates in mid-February, as well as, a higher day count - 23 days versus 19.5 days in February. Speeds are currently anticipated to fall moderately in April. Bear Stearns' Senior Managing Director Dale Westhoff says barring another rally, he expects the mortgage prepayment curve to flatten beginning with the April report with discount speeds supported by seasonals, while higher coupons speeds will compress under the flatter curve and reduced refi demand.
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