As 2011 dawned, the mortgage market was looking at the end of the Federal Reserve's second round of quantitative easing on June 30. There were also the prospects of rates creeping higher and spreads widening,

Technicals were expected to remain generally favorable with prepayment speeds benign, which is what clearly happened. Rates, however, have not quite responded as expected.

Despite rates going against expectation in 1H11, the second half of the year is beginning with favorable supply/demand technicals, attractive spread levels, and benign prepayments overall.

 Several FTQ Events in 1H11

The 30-year fixed mortgage rates were projected to average between 4.8% and 4.9% in 1Q11 while 10-year, notes were projected at between 3.1% and 3.2%. Refinancing share was estimated at 61% in 1Q11, declining to an average of 42% in 2Q11. Meanwhile, GDP was estimated at 2.6% in 1Q11, moving up to 3.1% in 2Q11.

The experience, however, has been that rates were higher than projected in 1Q11 at 4.9% for 30-year mortgages and 3.44% for 10-year Treasury yields, although they have declined in 2Q11 to an average of 4.7% and 3.21%, respectively.

Meanwhile, refinancing share has remained above 60% through the first half of the year, while 1Q11 GDP growth is expected at just 1.9% with 2Q11 now projected at 2.5%.

The first half of the year was plagued by several "flight-to-quality" events that ultimately pushed interest rates lower with the 10-year currently back to levels seen in early December 2010. These events included: unrest in the Middle East in January and February; the Japanese nuclear reactor disaster following the devastating earthquake and tsunami in March; and escalating worries about European sovereign debt that peaked over the last week as Greece reshuffled its government.

Woven in between all of these were the usual economic reports that started out encouraging, but weakened as the year progressed.

In fact, the recently released Beige Book indicated that the road to recovery is moving slowly and unevenly, with a third of the Districts reporting deceleration and the Federal Open Market Committee's most recent statement acknowledged that the recovery is slower than it expected and labor markets have also been weaker than anticipated. The latest Fed forecast for GDP has been downgraded to a range of 2.7% to 2.9% for 2011 from a previous projection of 3.1% to 3.3%, while the unemployment rate was ratcheted up to a range of 8.6% to 8.9% from a previous expectation of 8.4% to 8.7%. 

Manageable Treasury Sales

Congress was busy issuing various proposals that, for the most part, had limited market reaction as most were not surprising. The Treasury released its proposal on GSE reform called "Reforming America's Housing Finance Market" in late January. Given the fragile housing market, Treasury Secretary Timothy Geithner said that any changes would be phased in over five to seven years. Meanwhile, Republicans on the House Financial Services Committee were busy drafting eight bills on reform that will face stiff opposition in the Democrat-controlled Senate.

There was one unexpected announcement from the Treasury on March 21 that it would begin to unwind its $140 billion MBS portfolio starting immediately, with a goal of selling $10 billion every month. To date through May, the Treasury has sold $24.6 billion. There was an immediate adverse reaction primarily based on worries that the Fed would begin unwinding its portfolio sooner than expected. However, the markets quickly realized that would not be the case.

The additional supply was manageable for the sector as organic supply remained minimal - averaging $22 billion per month in net supply in 1Q11 and just $3.1 billion per month so far in 2Q11. In addition, paydowns from the Fed/Treasury/GSEs declined from late last year as prepayments slowed, while demand sources were willing and able to absorb supply/selling.

REITS turned into the "marginal" buyer for the sector over 1H11 (see cover story), raising some $7 billion since the end of last year, which translates to around $50 billion in buying power based on their typical leverage. The other major investors - banks, money managers, hedge funds, insurance companies, real money, and overseas - did their part as well to support the sector.

Prepayments Remain Uneventful

As expected, prepayment speeds held muted over the first five months of 2011. According to eMBS, speeds on FNMA MBS declined from a 25.9 CPR average in December to 12.8 CPR as of May (the latest report available). Meanwhile, FHLMC's are at 12.2 from 28.6 in December, while GNMA's dropped to 8.4 from 19.1 as of year-end 2010. Tight underwriting, a weak job market, declining home values, poor appraisals, mortgage banker constraints, and higher closing costs have kept prepayments benign even as affordability soared to record levels.

While prepayments are expected to increase over the near term as a result of the recent decline in mortgage rates, speeds are expected to remain below 2010 peaks unless mortgage rates drop to 4%. However, further tightening in underwriting is expected in the months ahead, and mortgage bankers are expected to be further constrained as a result of new rules.

In April the Fed requested public comment on a proposed rule under Reg Z of the Truth in Lending Act requiring creditors to determine a consumer's ability to repay a mortgage before making a loan and establishing minimum mortgage underwriting standards. The Fed is accepting comments until July 22. Expected also in the new fiscal-year budget are additional increases in Federal Housing Administration fees.

There will be new GSE guidelines in the fall for servicers' handling of delinquent loans as mandated by the Federal Housing Finance Administration (FHFA). These rules are expected to further constrain mortgage bankers. In late April, the FHFA issued a directive for the GSEs "to align their guidelines for servicing delinquent mortgages they own or guaranty." In early June, Fannie Mae issued new standards as a response to the directive, which will become effective on Sept. 1.

Specifically, the GSE formalized a timeline establishing a maximum number of days in which routine foreclosure proceedings are to be completed in the various jurisdictions with potential fines if the agency finds no acceptable reason for a delay. Also included were call center benchmarks that require the average speed to answer an inbound call to be 60 seconds or less; that responses for live chats to be initiated in less than or equal to five minutes from a chat inquiry; and that borrowers' e-mails must be responded to within 48-hours.

Since added resources will have to be allocated by servicers to deal with these tightened foreclosure timelines, some detraction from the day-to-day business of originating purchase or refinance loans is likely, UBS analysts said. They also expect these changes to result in even tighter underwriting standards as originators try to reduce the risk of the additional costs of complying with the guidelines. As a result, analysts expect that prepayments could decline marginally for credit-impaired borrowers as well as the more credit-worthy cohorts. Freddie Mac is expected to announce similar standards soon.

MBS Lag Behind Other Securitized Sectors

Despite the various flight-to-quality events over the first half of the year, investors have been keen on taking risk given the low yields/spreads on less risky assets.

As a result, competing sectors have outperformed MBS so far this year. Barclays Capital analysts said that excess return versus Treasurys on the MBS Index year-to-date through June 21 totaled 35 basis points compared to 75 basis points on ABS, 115 basis points on CMBS, and 81 basis points on corporates.

Current coupon spreads held into May to a fairly tight range of 70 to 75 basis points versus 10-year swaps and 80 to 85 basis points versus 10-year Treasury notes. Spreads have widened substantially to around 80 to swaps and 94 to Treasurys as investors became increasingly risk averse because of the Greek debt crisis with spreads.

While the Fed will conclude QE2 Treasury purchases on June 30, paydowns from MBS will still be reinvested in Treasurys, which will help keep interest rates low. Additionally, the Fed retained its language regarding an exceptionally low Fed Funds rate "for an extended period."

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