Trading in the mortgage-backed securities market this week was a tale about risk and reward.

Over the first two trading sessions of the holiday-shortened week, prices dropped and spreads widened sharply as investors repriced risk across the coupon stack. In the lower coupons, primarily 30-year 3.0s and 2.5s, it is increased supply; in credit-eligible 3.5s into 4.5s it is increased prepayment risk associated with historically low mortgage rates, while super premiums are faced with potential government initiatives to allow more credit-impaired borrowers to refinance, including through principal reduction, following President Barrack Obama's re-election.

Over Tuesday and Wednesday, MBS prices lost between 3/8 of a point on 30-year FNMA 3.5s to over 1/4 point in higher coupons while 10-year Treasury notes rose 7/32nds. Barclays MBS index underperformed Treasuries by 33 basis points in those two days which pushed month to date excess return to -69 basis points.

Meanwhile, the 30-year current coupon spread to 10-year notes widened nine basis points to +69 which wiped out all of the post-QE3 tightening. In addition to active selling from money managers and fast money, liquidity was very low in the markets with many investors on the sidelines.

By Thursday morning and continuing into Friday's session, there was a sense that the underperformance was overdone, particularly in light of the broader technical picture. With the reward in MBS now worth the risk following the post-election repricing, heavy buying emerged from hedge funds, money managers, banks, and overseas which added their weight to the Fed's.

While lower coupons were the primary focus, there was some nibbling in 5.5s and 6.0s from money managers, but they were quick to take profits on some strengthening. The result of the better tone was that Barclays MBS Index experienced 5 basis points of outperformance on Thursday, while the 30-year current coupon spread recovered two basis points of its widening.

Looking at the technical picture via mortgage banker supply against Fed buying, sales from originators averaged $3.0 billion per day – its normal level these days, while the Federal Reserve's buying pace over the holiday-shortened week ending Nov. 14 was $3.45 billion. In its monthly announcement, the Federal Reserve Bank of New York estimated it would buy $35 billion over the four-week period ending December 12 from paydowns it received in October from its MBS and debenture portfolios.

Combined with its $40 billion in outright purchases through QE3, Fed buying is expected to equate to nearly $3.8 billion per day.

In other mortgage-related activity, flows in specified pools were light but payups held firm; 15s outperformed in the first part of the week and lagged in the latter half, while GNMA/FNMAs were firmer later in the week on expectations of future increases in mortgage insurance premiums given the poor state of Federal Housing Administration's (FHA) reserves.

In a press release on Friday, the FHA reported that the capital reserve ratio of the Mutual Mortgage Insurance  Fund for the fiscal-year 2012 was a negative 1.44%. However, the agency said that this "does not mean FHA has insufficient cash to pay insurance claims, a current operating deficit, or will need to immediately draw funds from the Treasury."

The various measures it intends to take to return the ratio back to positive territory include one that in 2013 the annual mortgage insurance premium on new FHA loans will be increased by 10 basis points.

For the week through Thursday, Tradeweb volume was running near 100%. On performance measures, month-to-date return on the Barclays MBS Index was -64 basis points with year to date at +39. The 30-year current coupon yield was at 2.264 percent and spread at +67.


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