The lack of supply in mortgages continues to push rich valuations to even richer levels. As the end of the year approaches, there is a precedent for spread widening, with investors propping up their balance sheets.

The week was characterized by continued buying support from a variety of investors, especially banks, but no supply. Mortgage bankers brought less than $1 billion per day last week. Buyer interest focused on the up-in-coupon trade, particularly 30-year 6s that offer the best carry. Other factors with a positive impact on mortgages last week: the Treasury Refunding, declining vols and the outlook for a stable rate environment.

Over the Wednesday-to-Wednesday period, spreads on 30-year Fannie Mae 5s were two basis points wider, 5.5s were four basis points tighter, 6s were in 10 basis points, and 6.5s were firmer by nine basis points. Dwarf 4.5s were one basis point tighter, 5s were minus five basis points, and 5.5s and 6s were nine basis points better.

Credit Suisse First Boston recently noted that 30-year current coupon OAS's widened in 2001 and 2002. On the flip side, CSFB anticipates banks to be active in January as the year-end passes, and C&I loan demand to remain light.

In recent comments, RBC Dain Rauscher Senior Mortgage Analyst Kevin Jackson, sees potential for underperformance in the short run as well. His reasons include:

* The strong economic data of late raises the question of how long the Fed can hold off before increasing rates. This uncertainty would put upward pressure on volatility.

* While overall supply is down, there has been an increase in outstanding 30-year MBS over the past few months. This is because prepayments have started to slow. JPMorgan Securities, however, has suggested that the net supply for November and December should be around flat to negative again. At this time, speeds in November are anticipated to slow, but less than in October, and December speeds are looking to be flat to slightly faster.

* Rising rates and slower deposit growth have taken some of the bid out from banks.

* MBS OAS's are at the very low end of historical trading levels.

Mortgage applications slip on higher rates

According to the Mortgage Bankers Association (MBA), mortgage applications declined for the week ending Nov. 7 as rates increased. The Purchase Index was 7% lower to 375, and the Refi Index was down 10% to 2084. This was in line with analyst's expectations. As a percentage of total applications, refinancings were 50.9% versus 51.1% in the previous release. ARM share, however, rose to 26.6% from 25.4% as fixed rates increased.

Mortgage rates increased slightly as expected. According to Freddie Mac, the 30-year fixed-rate mortgage rate gained five basis points to 6.03%; the 15-year fixed-rate mortgage rate came in at 5.39% versus 5.31%; and lastly, the one-year ARM rate increased three basis points to 3.76%. With rates holding in narrow range, analysts anticipate the Refi Index will remain near the 2000 level next week.

No surprise on FNMA prepays, but not so for GNMAs

On Nov. 7, the housing agencies released their October prepayment reports. Fannie Mae was in line with consensus expectations. However, Ginnie Maes did not decline as much as was anticipated. For example, 2002 5.5s prepaid at 21% CPR versus a 13% estimate, and 2002 6s came in at 36% CPR versus a 28% CPR call. Citigroup Global Markets attributed the less-than-expected slowing in Ginnies to the timing of closings on FHA/VA loans and to the new GNMA hybrid ARM program. In comments from Bear Stearns, analysts suggest servicer buyouts contributed to the higher speeds. As an illustration, Bear considered GNMA 2002 5.5% pools serviced by Wells Fargo and Washington Mutual. The firm notes that Wells Fargo-serviced pools paid at 20.8% CPR in September and 18.4% CPR in October, a 12% decline. WaMu-serviced pools, however, rose 67% to 30.6% CPR from 18.4%.

Less of a surprise was that speeds on Freddie Golds slowed more than their Fannie Mae counterparts. For example, Freddie 2002 5.5s slowed 34% to 18% CPR versus a 25% decline to 19% CPR for Fannies, and Freddie 2002 6s prepaid at 36% CPR, a 26% drop, versus 38% CPR and a 21% slowing for Fannie Mae. Analysts expect convergence of Fannie Mae and Freddie Mac speeds with the refi wave over.

According to JPMorgan, agency fixed-rate paydowns totaled about $85 billion. The decline in paydowns has allowed the 30-year agency MBS market to increase for the third consecutive month. For October, the amount of outstanding fixed-rate MBS grew by more than $42 billion, says JPMorgan, and is the second largest increase in over a year. Analysts from the firm expect net issuance, however, to turn around in the next coupleof months.

Looking ahead to November's report, analysts expect further slowing in prepayments. This is due in part to an 18-day daycount versus 22.5 in October. The outlook for December is for speeds to be flat to slightly higher due to the decline in rates and increase in the Refi Index in September. In addition, the daycount is slightly longer at 21 days.

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