Mortgage spreads were hit early in the week on originator and servicer selling, and investor profit-taking to move up in coupon, brought on by a heavy sell-off in Treasurys following strong economic reports. From the April 8 close through Wednesday's close, the 10-year yield backed up 18 basis points. While there was originator selling, it was rather modest given the backup and averaged about $1.5 billion per day, mostly in 5% coupons. Daily servicer selling over the first three days of the week averaged $2.5 billion per day.
Late Wednesday, the tide started to turn as investors began moving down in coupon given the market's repricing and improved outlook. In recent comments from Bear Stearns, analysts remain bullish on mortgage spreads. They believe if rates continue to hold around current levels and originator pipelines continue to empty, risk (both refi and delta hedging) in the MBS market will continue to decline. At this time, they "would look to add spread duration (because the basis is likely to tighten) and shed some convexity (because implied volatility is expected to decline) at the right prices," the analysts said.
Most analysts, in fact, are favorable on the sector. UBS summed it up in their weekly report last week saying that: (1) less than 25% of the market is fully refinanceable at this point; (2) mortgages are within fair value range and carry is excellent; (3) technicals are favorable given the limited supply outlook, ongoing bank demand and expectations for the GSEs to start growing their portfolios; and (4) convexity hedgers have just a small impact at these rate levels.
Lehman Brothers, however, is one of the few firms that is not buying into the idea of shrinking supply and bank buying. On the supply issue, they say not to be lulled by negative net issuance in fixed-rate mortgages because it is just the lag between paydowns and issuance, and happens during every refinancing wave; and the purchase market remains strong - which suggests net issuance for 2004 will be high. On the bank support idea, they believe bank demand will be "inadequate" over the coming quarter. They estimate that banks will buy about $200 billion in mortgages this year. At this time, banks have bought 40% of that amount which suggests to Lehman that future support is limited. As far as GSE support goes, they believe spreads will need to widen an additional 10 to 15 basis points for the GSEs to be significantly active.
Over the Thursday through Wednesday period, option-adjusted spreads on 30-year Fannie Mae 4.5s and 5.5s were one basis point wider, while 5s and 6s were plus five and plus three basis points, respectively. Meanwhile, 15s did better as many investors moved into that sector as yields backed up. Dwarf 4s and 5.5s were three basis points tighter, while 4.5s and 5s were unchanged over the period.
As expected, mortgage application activity dropped on the dramatic increase in interest rates recently. According to the Mortgage Bankers Association (MBA), the Refi Index plunged 31% to 2862 for the week ending April 9. This is the lowest the index has been since Jan. 9 when the index was at 2196. The Purchase Index fell 9.5% to 432. As a percentage of total applications, refinancings were 50.4% versus 57.1% in the previous report. Not surprisingly, ARM share increased to 29.4% from 28.8%.
Freddie Mac reported increases in mortgage rates for the week ending April 16. No surprise given the heavy sell-off at the start of the week. The average 30-year fixed-rate mortgage came in at 5.89%, up 10 basis points from last week. Also, 15-year fixed-rate mortgages increased to 5.23% from 5.12%, and the one-year ARM rate was up four basis points to 3.69%.
At current levels, analysts expect the MBA's Refi Index will fall around 13% to the mid-2000s in this week's report. JPMorgan Securities add that at current rates, the Refi Index could stabilize around the high-1000s to low-2000s.
The impact of higher rates and a lower refinancing index will be felt beginning in the May prepayment reports. At this time, strong increases in speeds are anticipated in April for 5s and 5.5s with more moderate gains predicted in higher coupons. Consensus expects speeds in May to decline around 20% to 30% for 6% and lower coupons, with higher coupons falling around 10%. Specifically, 2003 5s are expected to prepay at 15% CPR in April and 10% in May versus 11% in March. Meanwhile, 2003 5.5s are predicted to increase to 34% CPR in April from 31% CPR in March, then fall to 23% CPR in May. Finally, 2003 6s are anticipated to increase to 47% CPR from 39% CPR, then fall to 38% CPR in May. Further declines of about 15% on average are estimated for June.