For the past few weeks, activity in mortgages has been below average with better selling as a result of the market uncertainty regarding future Federal Reserve action. Last week finally brought investors out on the additional clarity provided by the inflation data and Chairman Ben Bernanke's semiannual report to Congress. Flows started to pick up beginning Monday with pockets of buying noted as certain investors anticipated that mortgages would benefit from a downtick in volatility following the inflation data. In addition, there was expectation that many real money investors intended on putting money to work after Bernanke spoke.
Expectations of better mortgage performance following Bernanke's report were realized on Wednesday when a broad range of real and fast money began piling into mortgages as the market rallied sharply on the prospect that an end was nearing to the Federal Reserve rate hikes. Particularly noteworthy was some buying from Asian investors, which has been largely absent for the last several months. Servicers were also active, initially moving up in coupon, but as the rally strengthened, they reversed course and started adding duration.
Street analysts are neutral to positive on the sector currently. For example, JPMorgan Securities analysts in midweek research said they were retaining a neutral bias as they "expect future performance to be fairly Fed-dependent in the near-term." They also prefer up in coupon into 6s due to risks of the slowing housing market on prepayment speeds, and due to sponsorship concerns in lower coupons. UBS analysts are holding with their modest overweight, saying they "really like mortgages versus Treasurys." They note that mortgages appear slightly cheap to swaps, and believe that swap spreads have been far too wide to Treasurys.
Refinancings decline slightly
Mortgage application activity declined nearly 5% overall for the week ending July 14. The Mortgage Bankers Association reported that the Refinance Index was lower by 1.6% on a seasonally adjusted basis to 1377.6, while the Purchase Index also fell 6.2% to 398.5. Given the full week for activity coming after the holiday-shortened Fourth of July week and slightly lower mortgage rates, there was expectation that refinancing activity would be higher. However, the previous week did see a 1.5-day seasonal adjustment made by the MBA that likely contributed to the strong readings in the holiday-shortened week.
As a percentage of total application activity by dollar volume, refinancings were up slightly to 37.2% from 36.0% in the previous week. The ARM share was also higher at 42.3% from 41.0%.
Mortgage rates rise in latest FHLMC survey
Freddie Mac's latest survey for the week ending July 21 recorded a slight increase in mortgage rates with likely impact from Tuesday's sharp sell-off following the PPI report. Freddie Mac's Chief Economist Frank Nothaft said, "Financial markets were a bit jittery after core Consumer Price Index (CPI) figures for June were released that indicated inflation might still be a potential threat." He added that if this were true, the Federal Reserve would likely be more inclined to further raise rates this year. This way of thinking caused mortgage rates to rise, Nothaft stated.
"However, Fed Chief Bernanke, in his semiannual speech to Congress, hinted that another rise in overnight lending rates might not be imminent and financial markets breathed a collective sigh of relief, which should be reflected in the results of next week's survey," Nothaft added.
The 30-year fixed mortgage rate rose to 6.80% from 6.74%. This is the highest the rate has been since May 2002, and is 107 basis points above levels seen a year ago.
The survey also reported 15-year fixed mortgage rates averaged 6.41% compared to 6.37% previously. On the adjustable-rate side, 5/1 hybrid ARM rates rose three basis points to 6.36%, while one-year ARM rates increased to 5.80% from 5.75%.
While application activity is expected to trend lower, the rally following Bernanke's comments may have led to some stimulation in activity last week.
Prepayment outlook
Speeds in July are predicted to slow 12% to15% from June, primarily as the day count falls to 20 days from 22 days. With day count jumping to 23 days in August, speeds are expected to recover by around 8% to 10%.
Speeds should then steadily decline over the course of the fall and winter on the combination of the slowing housing market, higher interest rates, and declining seasonals. Lehman Brothers analysts project speeds by December on FNMA 30-years to decline from 4 CPR in the lower coupons to 7 CPR in the higher coupons from June's levels. On a percentage basis, this represents about a 40% decline from recent numbers.
The Street has been looking a lot at the effects of the less robust housing market on prepayments going forward. In the latest example, JPMorgan analysts recently examined this issue. "Ultimately, a slowing in the housing market will be reflected in prepayments, but this is likely to take more time," analysts from the firm wrote. Factors driving these views are that homeowners, specifically those in earlier vintages, still have considerable equity in their homes and that cashout activity should remain robust in the near-term. However, analysts are still keeping a careful watch on housing fundamentals.
With several signs of a slowing in the housing market - including greater inventories that are spending longer time on the market - analysts said some market participants believe these would result in a slowdown in mortgage prepayments. To confirm this, JPMorgan looked at speeds in the July prepayment report, which reflected June activity, and compared these numbers versus levels seen a year ago. The key to making these comparisons, however, is to adjust for the moneyness of each coupon, analysts stated. For instance, analysts compared recent speeds on approximately one-year seasoned 6s with speeds on similarly seasoned 5s a year ago. This comparison is valid because both coupons were about 20 basis points out-of-the-money. Analysts found that recent speeds are roughly 2 to 5 CPR faster compared to where they were a year ago, when looking at cohorts with similar moneyness. They added that a comparison of speeds on 5.5s now versus a year ago would reflect a slowdown from 20.9 to 10.6 CPR, but this does not adjust for the market sell-off that happened over this period.
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