Investors continued to lose their appetite for risk last week. While losses have been confined mostly to subprime, investor caution became very evident in the high-yield corporate sector as DaimlerChrysler was forced to postpone its $12 billion auto loan deal, which involves the sale of Chrysler Group to Cerberus Capital Management. In addition, KKR's leveraged buyout of Alliance Boots was postponed as a result of the market turmoil. In his August Monthly Investment Letter, Pimco's Bill Gross said that the subprime crisis is not "isolated" and is proving contagious to other markets. "The sudden liquidity crisis in the high-yield debt market is just the latest sign that there is a connection," Gross said, adding that markets are linked and "ultimately their prices and yields [are linked] to the fate of the U.S. economy."
There was a lack of good news on the housing front as well. Last week, Countrywide Financial reported disappointing earnings - $0.81 EPS versus expectations of $0.93 EPS - related to the poor housing market. In addition, in the company's press release, its outlook for the second half of the year was somewhat bleak: "Management anticipates that the second half of 2007 will be increasingly challenging for the industry and Countrywide," the release said. "Absent a reduction in mortgage interest rates, production volumes are expected to fall and competitive pricing pressures are expected to increase. In addition, volatility in the secondary markets has increased significantly early in the third quarter and liquidity for mortgage securities has been reduced as a result."
The slowing housing market has resulted in leading building products company USG reporting lower-than-expected numbers. "So far this year, the housing market has not exhibited any meaningful signs of recovery. The downturn in new residential construction is likely to continue throughout 2007," USG said.
These events kept the flight to quality on track. At midday last Wednesday, the 10-year Treasury yield was at 4.9%, its lowest level since the end of May. The turmoil kept MBS volume substantially below normal and flows mixed. Yield levels on the 10-year Treasury, however, have not yet spurred convexity buying. Alec Crawford, head of agency MBS strategy at RBS Greenwich Capital, said they calculate the current trigger for convexity buying at about 4.8% on the 10-year. They previously had estimated the 4.95% area, but the widening in mortgages has pushed it down.
Asian investors remained mostly sidelined, and the outlook for increased support from China appears less certain based on an article published in Asia Times. A couple of weeks ago, MBS were boosted by the prospect of increased buying by Chinese investors following comments from Housing and Urban Development Secretary Alphonso Jackson to Chinese officials. Jackson specifically promoted GNMAs, noting that the securities carry the same government guarantee as U.S. Treasurys but provide a higher yield. The Asia Times article, however, suggested that Chinese investors are not likely to take a chance on buying more MBS. The article said that Chinese economists believe MBS are now considered too risky as a result of the subprime meltdown and increased defaults. The article also suggested that China has most of its foreign reserves invested in U.S.-dollar assets and wants to diversify. Confidence in the rating agencies has also been hit. One economist quoted in the article said the rating agencies gave investment grade ratings on bonds they knew were risky. Another economist said with a possible bust in the housing bubble, now wasn't a good time to invest in MBS.
Originator selling was light through midweek at about $1 billion per day on average. Supply has been primarily in 6% coupons and to some extent 6.5s.
Mortgage Outlook
MBS are entering in their traditionally "more supportive" time of the month, though the risk aversion that is hitting the markets due to subprime, weak housing, and high-yield debt, is likely to temper this. The supportive factors include month-end buying activity, nonfarm payrolls, reinvestment of paydowns, and pool allocations. Tuesday is the end of the month, and Lehman's MBS Index is forecast to extend 0.08-years on Aug.1.
Street sentiment last week was in the neutral-to-negative area for MBS. For example, RBS Greenwich analysts said they are neutral but warn that if the bond market continues to rally, volatility is likely to move higher and further hurt MBS. Barclays Capital analysts actually moved to "tactically neutral" from underweight last week given the extent of recent losses in MBS. They said in the short term, there is potential for a snap-back in MBS returns based on history. Meanwhile, Deutsche Bank Securities researchers held with their underweight on the 30-year basis recommendation as a result of MBS weakening in both rallies and selloffs, along with the continued supply/demand imbalance. Countrywide analysts also recommended an underweight on mortgage-backeds given the negative environment for RMBS spread exposure, very wide swap spreads, high volatility and heavy supply from ARM-to-fixed refinancings. They suggest selling 30-year 6s and 5.5s versus five- and 10-year swaps so long as swap spreads keep widening.
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