Heading into 2011, several Wall Street firms favor an overweight to the mortgage basis. Valuations are expected to be attractive given the muted prepayments and generally favorable supply/demand technicals.

The issues facing borrowers - tight credit standards, mortgage banker constraints, poor home valuations, and a weak jobs market - are expected to persist next year, making refinancing difficult or too costly for many borrowers.

Additionally, mortgage rates are expected to creep higher over the course of 2011 from an estimated average of 4.7% in 2010. Given the diminished refinancing response from borrowers, Barclays Capital analysts said that"There is little chance that speeds will be materially faster than in 2010."

Mortgage banker capacity is not expected to expand significantly to help reduce pressure on primary mortgage rates. An issue has been the lack of staffing, and while lenders have been hiring, it is not enough to ease constraints nor is it expected to. There is a significant volume of work now required to underwrite and originate a loan, JPMorgan Securities analysts said, because of the increased scrutiny regarding documentation, appraisals and qualifications to reduce risks such as put-backs. In addition, Barclays analysts noted, staffing is being diverted from loan originations to loan modifications, foreclosures and fighting put-backs.

Barclays analysts previously stated that originators are essentially capped at 5000 on the Mortgage Bankers Association's Refinance Index. They expect this capacity limit to remain for the next six months.

"This has important implications because it not only caps the highest possible CPR, but also discourages lenders from offering attractive rates to borrowers, thereby containing overall refinancing volume," analysts said.

Housing prices are expected to remain weak in 2011, limiting many borrowers' ability to refinance or take cash out, as a result of the significant amount of inventory. Most projections predict another 5% or more decline next year.

"Excess supply looks likely to hang over U.S. housing for most of the next decade, shaping prepayment risk in MBS," said Steven Abrahams, head of securitization and MBS research at Deutsche Bank Securities.

Barclays analysts also expect that the housing market will be pressured for several years as a result of the shadow inventory that needs to be cleared.

At this time, the only risks to prepayments are seen as government-induced. In particular, it seems likely that Home Affordable Refinance Program (HARP), which is set to expire on June 30, 2011, is likely to get extended. If there are no changes, it will be status quo on prepayments, Barclays analysts said.

However, if the GSEs also eliminate the origination date requirement for HARP eligibility - before March 2009 for Fannie and May 2009 for Freddie - this could increase speeds on the 09-10 vintage coupons by 30% to 70% almost instantly, they said, "and we think there is a material chance that it could happen."

 

2011 Supply/Demand Outlook

The above factors will limit net organic issuance to around $76 billion in the base case, based on an average of various Street estimates. Shadow supply, however, is relatively substantial at around $200 billion from the Federal Reserve/U.S. Treasury's MBS paydowns that are not getting reinvested back into MBS.

The GSEs are also expected to add around $119 billion, primarily from Fannie Mae, through paydowns and some outright sales to meet the year-end 2011 retained portfolio cap of $729 billion. As of the end of October, Freddie Mac's retained portfolio was at $702.9 billion, while Fannie Mae's was at $798.3 billion.

Combined net supply between organic and shadow for 2011 is estimated to total $370 billion. If mortgage rates decline and refinancing picks up again, paydowns from the Fed/Treasury would increase and add to the net supply that the private sector would have to absorb, while higher rates will reduce paydowns.

This creates an interesting dynamic for net supply, Barclays analysts said, and "should contribute to basis directionality into 2011."

 

Demand to Just Meet Supply

At this time, the demand from banks, money managers and overseas appears to be able to absorb the net supply estimate of $370 billion. Banks are projected to buy around $140 billion, money managers $183 billion, and overseas around $38 billion.

Low loan growth and compressing net interest margins are seen driving the demand from banks. In addition, ongoing capital issues favor agency MBS - particularly GNMAs, especially as they work to comply with Basel III.

Money managers and relative value investors will play a critical role in the supply/demand technicals, Barclays, Deutsche and JPMorgan analysts agreed, with the Fed and GSEs not participating in the MBS sector.

At this time, money managers are still underweight and fundamentals are attractive, JPMorgan analysts said. It was also noted that mortgages are becoming more attractive relative to corporates, and there is the potential for some crossover buying to show up.

While money managers will be attracted to the yield, they will be cognizant of not taking on too much duration risk, Barclays analysts noted. As a result, they think these investors will be focused on up-in-coupon in 30s and 15s. The benign prepayment outlook is also a supportive factor to attracting these investors.

Overseas interest is uncertain and is dependent on the dollar and trade deficit. JPMorgan analysts noted that better overseas interest could be expected if the U.S. economy improves and the trade deficit grows.

Barclays noted that one factor that could lead to better overseas buying is that the Fed will be buying up a big chunk of Treasury supply over the first half of the year, leaving a limited amount available for private investors.

Headline risk associated with GSE reform will likely keep foreign investors tilted toward GNMAs over conventionals - a factor that should benefit GNMA/FNMA swaps, Bank of America Merrill Lynch analysts said.

Based on the current supply/demand outlook, MBS will be more vulnerable to rallies and sell-offs in 2011 versus 2010. "The supply/demand technicals in the agency MBS market are more favorable in a back up scenario," BofA Merrill analysts said, "as the runoff from the Fed/Treasury portfolio will be much lower in that scenario and the CMO demand is likely to be higher because of the steepness of the curve."

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