The debate on MBS supply going forward heated up last week, following the dramatic change in market conditions.
Lehman Brothers remains nervous about net issuance over the coming months. "The magnitude of the supply is a purchase market story and as such, should be less sensitive to interest rates," penned analysts at the firm last Monday. In an earlier publication, they had projected net issuance in mortgages to hit $200 billion to $250 billion a quarter going forward (see ASR 3/29). However, the economy appears to be "turning into a financing game," so the purchase market story will probably not hold as much weight given the recent backup in rates. Until this actually happens, however, Lehman still believes mortgage supply is going to be daunting in upcoming months.
Yet other analysts stated that net issuance in mortgages has never even reached $150 billion historically. Furthermore, net issuance figures for the mortgage market are generally not available on a timely basis, except for the fixed-rate sector. Net issuance in fixed-rates is expected to be in negative territory in the next couple of months due to the significant amount of refinancing applications in ARMs.
In a recent report, JPMorgan Securities made reference to competing Street research that stated that quarterly net mortgage supply would be just shy of $300 billion. "Our views could not be more divergent," wrote analysts at the firm. "The confusion appears to be related to a disagreement on the impact of existing home sales."
Previously, JPMorgan explained that in the last two years, outstanding mortgage debt has increased by $1.1 trillion. But less than half of this growth can be attributed to new home sales. They claim that equity takeout has been the main component of growth. The second most significant contributor to growth is new home sales.
Analysts at the firm also took issue with another competing firm that attributed rising LTVs to existing home sales. "We are simply dumbfounded by that view, as turnover is documented to be less than 10% per year," JPMorgan analysts wrote. They point instead to refinancing volumes as the cause for the reshaping of the mortgage market, and not turnover.
"We do not normally comment on Street research, but when bizarre claims become rampant we will put on our sheriff's badge and set the record straight," wrote analysts at JPMorgan. "The tightening in mortgages is already a clear indication that forward supply has been very modest."
As confirmation, the prepayment report released last Tuesday showed a net decrease in the amount of outstanding fixed-rate mortgages. JPMorgan noted that agency fixed-rate agency MBS prepaid at roughly 30% CPR, which equates to $88 billion in paydowns. Outstanding fixed-rate agency MBS dropped by about $20 billion.
In the May report (reflecting activity in April), analysts predict speeds on 30-year conventionals to increase 15% for 5s, 40% for 5.5s, 30% to 35% for 6s and 25% for 6.5s, which reflect a higher Mortgage Bankers Association (MBA) Refinancing Index. Given that supply is not significantly higher, net fixed-rate issuance should continue to drop, JPMorgan said.
Supply spills into jumbo ARMs
The resale component of the MBA Purchase Index remains high, as repeat sales continue to dominate housing activity. However, the spike in home prices has increased loan sizes, and this new supply is spilling over into the jumbo market, specifically into the jumbo ARM market, noted analysts.
"I don't think that new home sales are considerable enough to influence the supply numbers," said an MBS analyst.
The analyst pointed out that in light of the increase in home prices in many areas, someone purchasing an existing property would normally be forced to take out a larger mortgage compared to the original loan. However, the new loans have tended to spill over into the jumbo market rather than the conventional market. With the high prices, borrowers cannot afford to buy homes except by moving into an ARM or an interest-only loan, or a combination of the two. In this view, the rising average loan sizes, and not changes in LTV, have caused this shift in supply dynamics.
"I think this is why there has been a lot of production spilling into the ARM market, especially jumbo ARMs," said the analyst. In fact, he noted that there have been pools of jumbo ARMs that were made up of 90% interest-only loans, although the average IO component in these types of pools is 60% and growing.
With a lot of the supply moving into ARMs, issuance in conventional fixed-rate product is significantly below where it was earlier this spring, said the analyst. This is in contrast to 2003 when 30- and 15-year conventional gross issuance skyrocketed.
Chris Hanlon, senior vice president and director of mortgage securities at Hartford Investment Management Co., said that the market has seen some supply, but it seems to be well taken in by demand. Aside from the banks that have been fairly good buyers, GSEs will soon have sufficient incentive to buy mortgages.
"Our general view is that mortgages have been cheapening a little bit, so it's not going to take much longer before the agencies find the arbitrage in their favor and are able to grow their portfolios, issue callable debt and buy mortgages," said Hanlon. "Generally, there's been pretty good demand for mortgages so technically we believe mortgages are going to hold in pretty well and are relatively attractive."
Hanlon said that his firm had been fairly neutral relative to the Index. But the firm has recently been more closely aligning its investment strategies to the Index by closing their underweight in 15-year product and reducing their underweight in GNMAs. With borrowers now opting for ARMs instead of fixed-rate product, there will be less supply in the sector, making 15-years attractive. Moving into 15s is also a way to mitigate extension risk.
After the selloff two Fridays ago, supply concerns affected the lower coupons while easing prepay concerns helped the higher coupons. This has made down-in-coupon trades more popular with investors. However, Hanlon said that his firm prefers 30-year current coupon mortgages - 5s, 5.5s and 6s. There is some concern about 5s in light of the firm's outlook for higher rates, and Hanlon added that HIMCO likes 5.5s and 6.0s better than 5s.