NEW YORK - At Deutsche Bank Securities' semi-annual media briefing held last week, MBS analysts said that their outlook for the Agency mortgage market is positive, explaining that the current supply and demand situation in the mortgage sector supports spreads at these historically tight levels. Researchers also highlighted the current investor focus on credit-sensitive mortgages in non-Agency land.
Amin Majidi, head of MBS research at Deutsche Bank, said that the Agency MBS sector has experienced low spread volatility since the beginning of the year and that investors are still being rewarded by the carry trade. He added that the ABS and corporate sectors are currently tight versus mortgages, making MBS attractive versus these competing products
Majidi explained that diminishing supply and stable demand for mortgages are currently boosting MBS spreads, noting that he expects gross Agency fixed-rate supply to drop by 27% to $580 million this year. He said that the heavy bout of refinancing ended in 2004, and that most of the current refinancing activity is coming from borrowers moving into interest-only ARMs. Aside from this, bank and GSE demand for mortgages has remained stable. GSEs, for one, have been buying more adjustable rate mortgages they can fund at attractive spreads over short Agency debentures. In comparison, the GSEs' have allowed their fixed-rate MBS holdings to run off somewhat via prepayments. Meanwhile, although foreign purchases of Agency debentures have slowed down, foreign buying of MBS and corporates has not. Specifically, there has been noticeable interest from Asian investors not only in GNMA passthroughs - which has been typical - but also in CMO structures and ARMs as well.
Declining implied vols, due to yield-curve flattening, has reduced the convexity cost of carrying mortgages, Majidi added. The trend of declining implied or options volatility could continue unless the market breaks out of the current trading range in a meaningful way. Aside from breakout risk, volatility is not expected to rise as GSEs, servicers and the Federal Home Loan Banks have reduced fixed-rate mortgage exposure. These institutions have recently been purchasing shorter-duration assets such as ARMs, which have a much lower volatility exposure.
In a recent report, DBSI analysts wrote, "While convexity and vega exposures of the MBS market are compelling at this point, the reduction in the size of GSE portfolios, and the move by the agencies and servicers into ARMs, implies they are less likely to be a destabilizing force in a rally."
If rates rally by 50 basis points from current levels, the market would see accelerated prepayments on higher coupons and duration shortening on lower coupons. Majidi noted that convexity hedging in a rally could speed up the fall in interest rates even more. In a 50 basis points rally, the fixed rate market is expected to shorten by $320 billion 10-year Treasury note equivalents. In this scenario, GSEs and other convexity players would have to hedge the equivalent of $70 billion to $80 billion 10-year Treasury notes, Majidi estimates.
Majidi said that if rates rally 50 basis points from here, the 5.5 coupon (which currently makes up 41% of mortgages outstanding) would experience the highest prepayment risk and duration shortening. In the report, analysts wrote that 30-year 5.5s now contribute the largest amount of convexity risk to the MBS market and will probably underperform in a 25 to 75 basis point rally. But analysts also pointed out that higher prepayments are not yet forthcoming at this juncture.
In terms of 5% coupons, although a 50 basis point rally is not enough to make them refinanceable, it would expose this segment to significant convexity risk.
On the non-agency end, Majidi said that the aggressive lending of mortgage players to Alt-A and ARM borrowers has brought credit and servicer issues to the forefront, adding that since yields have dried up in the Agency sector, there is now tremendous investor interest in non-agency product. Majidi said that because of the increased focus on credit-sensitive mortgages - a trend that is here to stay - investors must pay closer attention to such factors as the borrower's LTV and FICO score, as well as subordination levels on individual deals.
However, despite potential credit issues, the housing market is not poised for an imminent crash. In his presentation, Majidi cited a recent article on housing published on The Federal Deposit Insurance Corp.'s Web site. The article argued that the regional housing price boom would not necessarily end in a significant decline in home prices, unless there a considerable economic shock experienced in the local economy. The most likely scenario following the recent considerable appreciation is a prolonged period of stagnating home values.
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