Volume was below normal in the first two days of trading last week as the market waited for the Federal Open Market Committee's (FOMC) decision on Tuesday afternoon.
As expected, the Federal Reserve made no changes to rates. The FOMC statement did place some emphasis on inflation, while noting concern on growth and the financial conditions. It said: "Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee. The Committee will continue to monitor economic and financial developments and will act as needed to promote substantial economic growth and price stability."
MBS spreads closed several ticks wider to both the curve and swaps both Monday and Tuesday on better selling overall by hedge funds, money managers and servicers. Following the FOMC's statement, there was a brief round of buying from this same group that pulled spreads off their wides of the day, although this attracted selling from real money and domestic banks.
Notably absent have been Asian buyers, and they are not expected to be too active until the market settles down. Up-in-coupon outperformed while specified pools experienced light interest, and GNMA/FNMAs were mixed. Originator supply also weighed on the market despite levels of just $1 billion per day due to the buyers' strike.
On Wednesday, mortgages were slammed by Freddie Mac's negative earnings release. The GSE reported a loss of $821 million, or $1.63 a share, and said it still plans to raise $5.5 billion or more in capital.
Additionally, the agency said it would consider other strategies to maintain its capital position, such as slowing purchases into its credit guarantee portfolio and limiting the growth or reducing the size of its retained portfolio by allowing the portfolio to run off and/or by selling securities classified as trading or carried at fair value under the Statement of Financial Accounting Standards, or SFAS, No 159, or available-for-sale securities that are accretive to capital.
At mid-morning, spreads in the belly of the stack were wider to the curve by 21 ticks in 5.5s and 11+ in 6s. As one trader noted, the news is not good for the basis, rolls, Gold/FNMAs or higher coupons. There was some selling from fast money and convexity, and light buying from real money on the cheapening.
As of press time, Fannie Mae was scheduled to report its earnings on Friday.
Month-to-date through Aug. 5, Lehman Brothers' MBS Index was lagging Treasurys by 45 basis points. The sector is also lagging its competitive sectors: ABS negative two basis points, CMBS 24 basis points and U.S. credit nine basis points. Year-to-date, however, the sector compares favorably to the other sectors: MBS negative 124 basis points, ABS negative 559 basis points, CMBS negative 597 basis points and U.S. credit negative 373 basis points.
Mortgage Outlook
Analysts' tone was mostly favorable toward the mortgage basis last week. For example, JPMorgan Securities analysts maintained their overweight versus both swaps and Treasurys due to the fundamental cheapness of the sector. They added that current levels have been attracting hedge funds and money managers, while banks have been better buyers than expected.
Citigroup also favored the mortgage basis given the extremely attractive levels. Also a plus, they think, is the declining supply outlook. UBS analysts held with their overweight as mortgage valuations remain attractive. They favored an underweight to GNMA Is versus conventional counterparts.
Deutsche Bank Securities analysts were more cautious, expecting the MBS basis to be range-bound over the near term, while the longer-term trend will be wider, they believed.
While valuations are viewed as attractive, the limited support from Freddie Mac and ongoing deleveraging suggests that even better valuations are on the horizon. Overall, flows are expected to remain limited and two-way with investors keeping to a "day-trading" mentality.
Mortgage Applications Rise
Mortgage application activity rose 2.8% in the week ending Aug. 1 in response to slightly lower mortgage rates. The Mortgage Bankers Association reported that the 30-year mortgage contract rate slipped five basis points to 6.41% and the one-year ARM rate was eight basis points lower to 7.17%.
The MBA reported that the Purchase Index rose nearly 2% to 337.2 and the Refinance Index was up 4.4% to 1121.8. Still, outside of the previous week's nearly 23% drop to 1074, the Refinance Index level is at its lowest since the end of 2000.
As a percent of total applications, refinancing share increased slightly to 35.9% from 35.2%. ARM share fell to 6.9% from 7.3%.
Prepayment Outlook
August speeds are expected to slow close to 10% from July's numbers. Contributing to this is one less collection day in August, along with higher mortgage rates and modestly lower refinancing activity in July. For the month of July, the Refinance Index averaged 1289, down 6% from June's average of 1371, while the 30-year fixed mortgage rate, as reported by Freddie Mac, averaged 6.43% compared with 6.32%.
Higher g-fees from Fannie Mae also will have implications for speeds. The GSE announced last week that it was increasing the adverse delivery charge to 50 basis points from 25 basis points beginning Oct. 1. The GSE already increased fees on March 1 and again on June 1.
In a report, Barclays Capital analysts looked at why it seems that the biggest rise in upfront fees is being applied to the 75 to 80 LTV bucket and not 80 to 85 or greater than 85 LTV.
Analysts think that the reason is related to the amount of primary mortgage insurance (PMI) coverage that is required for different borrower LTVs.
Fannie Mae's new LTV matrix presents percentages detailing the coverage amount of the loan - and not of the home value.
For instance, for an 80% LTV borrower with a $100 home, 12% PMI covers $9.6 of the loss and Fannie Mae would be responsible for $70.4.
However, if the borrower took out a 90% LTV loan, 30% PMI would cover $27 of the loss and Fannie Mae would be responsible for only $63 of the loss. Barclays analysts said this would imply that the agencies are more exposed to borrowers with LTV in the 80% to 85% range than in the greater than 90% range.
They are even more exposed to 75% to 80% LTV borrowers who would be unlikely to have any PMI.
Net Issuance to Slow
Lehman Brothers and JPMorgan Securities analysts reviewed the outlook for net issuance for the remainder of the year.
Lehman's conclusion is a slowdown in the pace of monthly agency net issuance to around $35 billion to $40 billion from $50 billion. Furthermore, of this amount, the firm projects over 50% to be in GNMA paper (not counting the pickup from the Hope for Homeowners program).
JPMorgan's projections are similar, in the $30 to $40 billion range through the rest of the year, down from the $50 billion to $60 billion per month in the first half of the year.
Factors contributing to the lower supply include the higher agency g-fees, ongoing tightening in lending standards, reduced lending capacity, declining home prices and weakening seasonals heading into the fall, analysts said.
Lehman's report considered the components of agency net issuance in determining its outlook, which is broadly new purchase originations, non-agency-to-agency refinancings and agency-to-agency cash-out refinancings.
Specifically, regarding the non-agency universe, analysts pointed out that the bulk of it has little rate incentive to refinance - approximately 1% of the outstanding prime universe and 3% of the alt-A universe has at least a 50bps incentive to take out an agency loan, they estimate.
In the subprime space, however, there is at least 30% of that universe that has an incentive and can qualify. Lehman analysts expect, however, that this group of refinancers will choose a Federal Housing Administration loan versus a conventional one.
Assuming current rates, Lehman predicts annual non-agency-to-agency refinancing volumes of around $105 billion. Even if rates increase 50 basis points, they don't expect much decline in refinancing volumes.
In new purchase originations, they calculate roughly $800 billion of annual purchase originations coming from the current level of sales in single-family existing homes and new home sales. They estimate 50% of these originations are going into the agency market.
So what does this all mean for MBS? JPMorgan analysts believe the lower supply should help alleviate some of the concerns regarding MBS sponsorship.
"We expect that a $25 billion to $30 billion falloff in supply will more than offset any weakness in agency portfolio growth or foreign purchases in the months ahead," analysts wrote.
Meanwhile, Lehman believes the pickup in Ginnie Mae issuance could overwhelm the current valuations of GNMA/FNMA swaps. As a result, they "recommend an underweight to GN/conventional swaps in 5.5s and 6s to benefit from the pickup in GNMA issuance."
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