The outlook in early 2004 looks positive for mortgages due to strong carry, a range-bound rate outlook, a continued steep yield curve, slowing prepayments, higher Treasury issuance with lower mortgage issuance, and a normal uptick in buying following the year-end. The range-bound outlook got support from the November personal income and outlays report. According to Lehman Brothers economists, the data confirms the disinflationary trend as the core PCE deflator continues to decline. This measure is the Federal Reserve's favorite for inflation, and is currently below the Fed's likely target, said Lehman's economists. They conclude from the report that "the Fed has a long way to go before they can consider raising rates."

While the outlook is positive, mortgages continue to be rich. This has some potential negative ramifications. According to recent comments from Morgan Stanley, the GSEs would slow their mortgage portfolio growth as a result. This was seen in the November business reports from both Fannie Mae and Freddie Mac. If this continues, the GSE's funding needs would decrease. Therefore, says Morgan Stanley, the mortgage/agency basis should remain a focus factor due to ramifications of potential supply.

Another risk to the market is call rather than extension, says Nomura Securities International. The MBS Index has extended to 3.6 years from 1.3 years last February, and Nomura believes that much of the conceivable extension for the market has already occurred. Risk of underperformance (beyond curve flattening which removes the carry trade) comes with a 10-year yield of 3.75% or below. However, this is highly unlikely.

Refis rise

For the week ending Dec. 26, the seasonally-adjusted Refinance Index declined by 13.8% to 1644.3 from 1908.3 the previous week, according to the Mortgage Bankers Association (MBA). The seasonally-adjusted Purchase Index slipped 5.2% to 390.1 from 411.6 the prior week. The MBA also reported that the refinance share of mortgage activity declined to 49.3% of total applications from 51.7% the prior week.

Freddie Mac reported slight increases in mortgage rates for the week ending Jan. 2, 2004. The 30-year fixed rate mortgage was up a few basis points to 5.85% from 5.81% the previous week. Meanwhile, the 15-year fixed rate mortgage rose to 5.15%, increasing marginally from the previous week's rate of 5.13%. The one-year ARM rate declined very slightly to 3.72%, down from 3.73% the previous week.

Commenting on ARM rates, Freddie's deputy chief economist Amy Crews Cutts said, "The yield curve, at its steepest annual level since 1992, is indicative of a favorable ARM market." She added that the market has already seen the ARM share of applications double in 2003, and it now makes up close to a third of the market.

Cutts stated, "With the Federal Reserve on hold until at least June, the yield curve should continue to be steep and once we begin to see signs of inflation, it may well become even steeper, at least until the Fed raises short-term rates." Until this happens, Crews Cutts stated that savvy homebuyers can lower their monthly mortgage payments by choosing one of the many ARM products available in the market today.

Regarding the level of the Refi Index to current mortgage rates, a recent report by Bear Stearns notes that the borrower burnout response contrasts sharply with the period in late 2002 when rates hit the 6% area, sending the Refi Index to 7000. At this time, Bear estimates that 30-year mortgage rates would need to fall around 50 basis points to 5.45% to send the index back over 6000. That event is not seen as very likely at this time. As a result, Bear says the mortgage market should remain rich into 2004 due to the steady prepayments, limited supply, and the normal increase in demand after year-end.

Also of note regarding the current fixed mortgage rate levels is the increasing share of adjustable rate mortgages. If the fixed-to-ARM refinancings continue, this may benefit discount coupons with faster speeds than otherwise might be expected says Bear.

The decline in application activity will help prepayments to continue to slow in the near-term. As of press time, consensus anticipates speeds in December to be flat, while January and February reports should show modest declines. The December prepayment report is released on Thursday, Jan. 8.

GSE report negative on help to homebuyers

The Fed released a study on Dec. 23 regarding the benefits to consumers of the GSEs' relationship to the government and homeownership. It turns out, however, that benefit may not be so great. The study said the government's implicit backing of the GSEs tends to benefit the shareholders, but does not significantly spur homeownership. The study also concluded that the implicit backing amounts to a subsidy and accounts for a good part of the companies' market value. It valued the subsidy at between $119 billion and $164 billion with shareholders retaining $50 billion to $97 billion. In addition, the analysis estimated the GSEs' participation in the secondary mortgage markets lowered borrower costs by an average of only seven basis points, not the 25 basis points the Congressional Budget Office estimated in an October report. The study said this impact on mortgage rates was not enough to qualify more people for mortgages.

The report noted the GSEs ties to the government allowed it an average 40 basis point funding advantage versus private-sector competitors over the period 1998 through mid-2003. Despite this advantage, the study concluded it was difficult to pass the lower funding costs through to homeowners. The author of the report, Wayne Passmore, said "to pass these lower costs on to homeowners requires that GSE shareholders not capture this subsidy in the form of increased profits."

This news is not good for the GSEs that are currently facing potential regulatory reforms. The report provides ammunition for those lawmakers who favor removing the GSEs' line of credit to the Treasury. The study said that without this relationship, the GSEs would lose their triple-A credit rating unless they raised more capital or took other action to offset the loss of their status.

Fannie Mae's CEO, Franklin Raines, disputed the findings of the Federal Reserve report. He said proof was in the difference between jumbo rates and conforming rates - which average between 25 and 50 basis points - depending on current market conditions. He also suggested the jumbo market benefits from the liquidity of the conforming market and that "the jumbo-conforming spread actually underestimates the spread that would exist if there were no such spillovers."

Raines also noted that consumer behavior demonstrates they recognize the benefit of conforming loans. The proof here is in "piggyback" loans where a borrower will take out a conforming first loan, and then a second mortgage for the remaining principal balance. Another suggestion regarding consumers' preference for conforming loans is their preference for long-term fixed rate mortgages. Raines noted that only 50% of the jumbo market is fixed-rate versus 85% for the conforming markets. The jumbo market contains a higher percentage of ARMs.

A copy of the Fed's study can be found on its website at:

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