The supply/demand outlook for the mortgage market changed in the blink of an eye on Wednesday with the unexpected Federal Open Market Committee (FOMC) announcement that the Federal Reserve will once again be buying MBS starting on Oct. 3.

"To help support conditions in mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities," the FOMC said.  

As mortgage rates began to drop sharply in August, the supply/demand dynamic was becoming increasingly adverse as paydowns from the Fed/GSE/Treasury portfolios were increasing as a result of higher refinancing activity.

At the same time, the demand side of the equation was shrinking as money managers were overweight already while REITs were essentially sidelined beginning in September. This was because of the Securities and Exchange Commission announcement that it was reviewing REIT's treatment under the Investment Company Act of 1940. Spreads were pressured and expected to continue to widen to draw in private investors to absorb the excess supply.

MBS analysts' outlook now is for Fed buying to total between $15 and $20 billion per month over the next several months at current rate levels.

Technicals have now turned favorable once again with Credit Suisse saying in a report that demand over the next three months is likely to exceed supply by $110 billion in a 4% primary mortgage rate scenario. Barclays Capital analysts noted that there should be less basis directionality now as Fed demand will absorb the increased supply.

It was not surprising that the FOMC's statement had the "Operation Twist" decision. This extended the average maturity of the Fed's securities holdings through buying $400 billion Treasurys with remaining maturities of six to 30-years and selling an equal amount of Treasurys with remaining terms of three-years or less by the end of June 2012.

The Committee said that, "This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative."

The markets were clearly anticipating the twist action from the Fed and had been preparing for this as reflected in the steady flattening of the yield curve in recent weeks.

Even in mortgages, investors had been moving down in coupon on Tuesday, in part, as lower coupons were expected to benefit more from this action. Prior to the FOMC announcement, aiding the bid in production coupons was a sharp decline in yields on the continued flight to safety bid driven by European sovereign debt worries, concerns related to global economic growth, and downgrades by Moody's Investors Service on the long- and/or short-term debt ratings of Bank of America, Wells Fargo and Citigroup with a negative outlook on the long-term debt rating for all three. Moody's said the downgrade was because of the lower probability that the U.S. would support these institutions if needed.

Prepayment Outlook

While the Fed's actions will lead to even lower mortgage rates going forward, credit-impaired borrowers remain unable to take advantage as credit conditions remain tight, home values low, with the economy and jobs markets weak.

Changes to the Home Affordable Refinance Program (HARP) are expected at some point, but a speech on Monday from  Federal Housing Finance Agency (FHFA) Acting Director Edward DeMarco suggested nothing particularly transforming was in the cards.

Fairly clear was a gradual increase in g-fee pricing "to better reflect that which would be anticipated in a private, competitive market," he stated, adding that these increases "should be expected in 2012."

DeMarco also pointed out that the purpose of the HARP was not to mass-refinance everyone, but the program "was designed to address a particular segment of borrowers with loans guaranteed by the Enterprises." 

Meanwhile, he said that "continued declines in house prices and recent declines in mortgage interest rates to historic low levels suggest that more households could benefit from this program and, importantly, such refinances could reduce the Enterprises’ credit risk."

Under this premise, expanding the HARP to post-May 2009 originations seems unlikely. DeMarco even stated that most creditworthy borrowers outside of HARP's parameters should be able to refinance their mortgages through normal channels.

However, a selective expansion for 80+ LTV borrows is a possibility, Credit Suisse analysts said. They noted that the further declines in home prices over this period have increased LTVs for borrowers who had original 80% LTVs, and so it is more difficult for them to refinance.

Under this selection, Credit Suisse analysts said that potentially up to 3 million borrowers would be able to refinance, although for various reasons, not all would be able to. They estimated the impact would be around 5 CPR for 2010 4.5s and 2 CPR for 2010 5s.

In his speech, DeMarco also said the FHFA was trying to identify possible enhancements to HARP to help borrowers refinance, including loan-level pricing adjustments, reps and warranties, valuation requirements and portability of mortgage insurance as well as barriers like the 125% LTV cap.

The current outlook for speeds in September is for around a 10% increase overall with CPRs on 4s through moderately seasoned 5s increasing between 30% and 50%.

Meanwhile, credit-impaired coupons are projected to be mostly slower. Speeds had been expected to peak in October, which will be reported in November, at less than 5% higher than September's estimates. However, the Fed's actions and lower rates will likely lead to upward revisions in coming weeks.

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