With the recent MBS widening trend and other negatives - particularly extension risk and diminishing demand - plaguing the MBS sector, many market participants are not looking so kindly on mortgages.
"All the bad things that we had feared for the mortgage market are finally coming through," wrote Lehman Brothers analysts in a recent report, though acknowledging that the market has already started to price in many of the risks that they had previously warned against. Currently, spreads do not look "terribly attractive yet," and extension risk is not the real issue at this point, according to Lehman analysts. "We do not think the supply of duration due to mortgage extension is the true cause of mortgage cheapening," analysts said, attributing the recent sector underperformance instead to a lack of demand. Analysts noted that although the GSEs could provide a backstop at some point, it would not necessarily lead to spread tightening. Also, the market's overall bearish tone has soured rate-driven buyers while diminishing carry as well as risks from a weakening housing market have pushed away investors who are after mortgage spreads or carry.
Chris Hanlon, director of mortgage-backed and government securities at Hartford Investment Management Co., said that MBS has cheapened on an OAS and price regression basis, though only for the short-term. "Longer term the sector is not very cheap," Hanlon said, noting that having no real roll advantage compounds the problem. He added that what is driving valuations right now is lackluster demand. As the market approaches year-end, dealer positions are long and although the GSEs are buying at the margin, it is not enough especially with Fannie Mae a net seller for capital adequacy reasons and Freddie Mac adding to its portfolio but not through residential mortgages. The GSE arbitrage is currently at relatively wider levels than it has been previously, making it advantageous for the GSEs to issue debt to fund mortgage purchases. However, until final GSE legislation has been enacted, it is going to take time for Fannie Mae and Freddie Mac to be aggressive mortgage buyers once again, Hanlon added. Domestic investors have not been that active either. The question, Hanlon said, is whether at the current interest rate range, foreign investors will be buyers in refunding auctions. But so far, there has been very low indirect participation. "The tone of the market has been fairly negative," Hanlon said.
With recent cheapening, it is easy to be aggressive MBS purchasers in the near term, although the sector is "not a screaming buy for us," Hanlon said, adding that he is currently fairly neutral on the mortgage basis and that he is waiting for the market to go back to its previous trading range. At current Treasury levels, the sector is close to becoming a "buying opportunity," but if Treasury rates drift higher, mortgages will lag. HIMCO has reduced some of its agency debenture holdings but "it is not large and on the margin," Hanlon said.
Although many investors are currently concerned about extension risk, as evidenced by the recent proliferation of up-in-coupon trades, Hanlon stated that, "the bulk of the market is still being driven mostly by demand technicals."
Art Frank, head of mortgage research at Nomura Securities, said that mortgage spread widening peaked last Monday, and was followed by two consecutive days of tightening. "Compared to the past year, spreads are wide but we've seen them much wider than this," he said. Frank is currently near-term neutral on the mortgage basis as he thinks there is a possibility of weakness going into year-end with fairly heavy MBS dealer inventory. However, Frank expects mortgage spreads will likely perform better in early 2006.
Frank does not see extension risk as a major threat to the MBS market. "Most of the extension has already happened and the mortgage market is pretty non-refinanceable at this point," he said, noting that the Mortgage Bankers Association Refinancing Index has stayed below 2000 for the last three weeks. He expects a more muted refinancing environment going forward, with only 6.50% and higher coupons in the refinanceable window.
In terms of MBS demand, Frank said that the sector is not cheap enough for domestic investors, such as insurance companies and banks, to buy aggressively. Additionally, Frank expects widening pressure in December as institutions close their books for the year. The GSEs might "ramp up a bit as spreads widen but it would be politically foolish for them to resume their previous explosive 30% to 40% growth while the Senate is debating regulation that could severely restrict portfolio growth," Frank said. Meanwhile, he expects foreign demand to continue as long as mortgages remain attractive relative to other fixed-income sectors.
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