As 2011 MBS outlooks were being formulated, mortgage rate levels were much lower. This lead to expectations of increased paydowns from the Federal Reserve, theU.S Treasury and the GSEs as a result of the elevated prepayment speeds.

However, some interesting events occurred during 1Q11 to adjust the prepayment and supply landscape. These include such factors as mortgage rates reaching in mid-February their highest level in 10 months, higher loan fees, extension of the Home Affordable Refinance Program (HARP) and the Treasury announcement that it would immediately begin unwinding its agency MBS holdings.

Overall, prepayment speeds are expected to remain muted given the prospect that mortgage rates will generally be trending higher as the economy improves, while the Treasury's MBS sales are considered manageable.

 Day Count/Turnover Influence Prepays

Over the foreseeable future, turnover and day count are considered the major influences on prepayment speeds since only a small percent of credit-eligible borrowers have an incentive to refinance at current mortgage rate levels.

While turnover will begin to pick up in the spring, as this season is the traditional home buying period, JPMorgan Securities analysts said it will be historically more muted because of the housing market's weak state. Analysts said that traditionally the level of housing turnover increases 50% from January to June, which can add as much as 3 CPR to 4 CPR to baseline speeds. However, in the current environment the seasonal pickup will be 30% to 40% lower and will add merely 2 to 2.5 CPR to speeds in the coming months, analysts said.

Refinance opportunities for credit-eligible borrowers are expected to generally deteriorate over the year as interest rates are expected to steadily increase as the economy continues to recover.

The strengthening economy is expected to allow the Fed to conclude the second round of quantitative easing at the end of June and then begin the process of further removing its accommodative stance, which will also pressure interest rates higher. Currently, 30-year mortgage rates are expected to average 5.5% by 4Q11 - increasing 110 basis points from 4Q10 - and be over 6% by the end of next year.

Opportunities for credit-impaired borrowers to refinance will remain difficult. This is a result of credit conditions continuing to be tight and home valuations remaining weak as distressed home sales weigh on the housing market. For instance, the latest Standard & Poor's/Case-Shiller Home Price Index for January showed that the 20-City Composite declined 3.1% from a year ago, with 11 cities posting new record lows, while the 10-City Composite was down 2%.

David Blitzer, chairman of the index committee at S&P, was not particularly optimistic about the outlook. "Keeping with the trends set in late 2010, January brings us weakening home prices with no real hope in sight for the near future," he said. While a double-dip in housing has not occurred, it is close with the 10- and 20-City Composites only 2.8% and 1.1% above their April 2009 lows, Blitzer reported.

Barclays Capital analysts have previously said that they expected home prices to fall another 3% to5% before stabilizing while Wells Fargo analysts think home prices could continue to decline over the next three years. Likewise, Deutsche Bank Securities researchers predict that home prices will continue to slide this year and next, while holding flat the year after.

To summarize, refinancing activity is expected to decline to a 29% share by 4Q11 from a 78% share as of 4Q10. It should also hold around that area through 2012. Purchase originations are also expected too overtake refinance originations beginning this year. As a result, prepayments should remain relatively benign.

Meanwhile, influencing June FNMA speeds is the recent change in Fannie Mae's HARP eligibility date to May 31, 2009, from March 1, 2009. Bank of America Merrill Lynch analysts expect speeds to pick up for FNMA pools that were originated during this period. Using Freddie Mac's experience as a guideline, BofA Merrill analysts project that speeds could be faster by 5% to 6% CPR for 5s at current or lower mortgage rate levels. Under a 50 basis point back-up, they said the increase should be less than 2% CPR.

GNMA speeds are expected to be slightly slower in the months ahead. This is the influence of the tightening in the Federal Housing Administration underwriting that began in October with a 35 basis oint increase in the annual premium to the latest 25 basis point increase in the mortgage insurance premium that becomes effective in mid April.

Scott Buchta, head of investment strategies at Braver Stern Securities, said that around 85% of FHA borrowers are out of the refinancing window.

Barclays analysts added that altogether these changes have raised the effective mortgage rate for Ginnie Mae borrowers by around 100 basis points. This has pushed 5.5% and lower coupons out of the money at current rate levels. Analysts expect that by the May report (to be released in June), voluntary prepayments on the major GNMA cohorts will be in the single digits.

Supply-Demand Update

The recent announcement from the Treasury that it will be selling its agency MBS holdings shifted the supply landscape for 2011 - increasing the volumes modestly from the initial 2011 outlook.

Based on various Street estimates, organic supply is projected at $70 billion, while shadow supply coming from the Fed, the Treasury and the GSEs is projected at around $330 billion.

There was $400 million in net supply versus an initial outlook for the year of $370 billion. Limiting the damage done from the Treasury's unexpected plan has resulted in a decline in paydowns from the Fed/GSE portfolios as higher mortgage rates have led to prepayments slowing.

Despite the net increase in supply, the active buying from REITs has not really altered this year's outlook in terms of the supply and demand balance.

REITs have raised $7 billion in capital this quarter and, based on various leverage ratio assumptions, analysts project MBS demand of between $40 billion and $90 billion from this group. As a result, net supply at this time is balanced to slightly higher versus demand for 2011.

The slight imbalance and the timing differences between occasional excess supply versus demand suggest some MBS spread widening over the near term.

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