The shortened trading week was anything but uneventful. After heavy global equity losses caused by increasing recession fears, last Tuesday the Federal Reserve made a surprise 75-basis-point cut in the Fed Funds and Discount rates to 3.50% and 4%, respectively.
In its statement, the Federal Open Market Committee said: "The Committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets."
Following the news, MBS flows were heavy and two-way as investors responded to the rate cut as well as the prospect of more rate cuts to come. Servicers aggressively moved down-in-coupon as they added duration largely in 5s, but also in 4.5s. Other investors were more two-way, including money managers that were focused primarily in the higher part of the coupon stack. Both overseas and domestic banks were reportedly better sellers. With the strong rally and prospect for lower rates, higher coupons felt pressured in the face of renewed prepayment fears, which specifically affected the 6 fly. Specified loan balance premium pools were in demand, some of which came from CMO desks. Rolls also improved because of the rate cut, with implied funding levels falling to around 3.50%.
Flows were more mixed on Wednesday with better selling. Money managers were actively selling 5s and 5.5s after their strong run-up on Tuesday as well as moving up-in-coupon into 6s. Meanwhile, 5s were reportedly seeing two-way flows from hedge funds. Servicers remained active in the lower part of the stack. Originator supply stayed at less than $1 billion. Sources suggested that servicers were keeping the supply from their origination businesses.
Mortgage Outlook
Street analysts have appeared to take a neutral to positive stance on mortgages. UBS analysts, for example, said that they remain neutral given the current market volatility. They added that their model shows mortgages to be rich.
Barclays Capital analysts, on the other hand, upgraded their recommendation to bullish from neutral on the mortgage basis. Some of the positives they noted were a more accommodative Federal Reserve, reduced risk of slower prepayments in the lower part of the stack since the MBS universe is above par (in fact, analysts said that the slower speeds are now a positive for this sector), as well as the potential for reduced credit losses in the GSEs' guaranteed asset portfolios. This lessens the need for the agencies to sell much of the MBS from their portfolios to build capital.
However, all is not rosy as ongoing write-downs keep the risk of bank selling elevated, which is made worse by the improvement in the dollar prices. The higher dollar prices also will keep certain investors, such as yield buyers and overseas investors, closer to the sidelines, Barclays analysts said.
Application Activity Rises
As expected, mortgage application activity increased in the week ending Jan. 18 in response to dramatically lower mortgage rates. The Mortgage Bankers Association reported that the Refinance Index rose 16.9% to 4178.2. This is the highest level since late March 2004 (4857) when 30-year mortgage rates were at 5.40%. Meanwhile, the Purchase Index slipped 4.6% to 439.9.
"Refinance applications are up 92% since the beginning of November and purchase applications are up 7%," said the MBA's Vice President of Research and Economics Jay Brinkmann. "With tighter credit conditions we do not know how many of these applications will become loans, but it is clear that borrowers are responding to the 40- to 80-basis-point drop in rates we have seen since Nov. 2 across products."
As a percent of total applications, the refinancing share rose to 66% from 62.7% previously. ARM share remained almost the same at 9.3% versus 9.2% in the last report.
The MBA also reported a 13-basis-point decline in the 30-year fixed contract rate to 5.49%. The one-year ARM was also lower by 26 basis points to 5.51% from 5.77%. With rates even lower following yesterday's Fed rates cut, further gains in activity are expected in next week's report.
Prepayment Outlook
Prepayment speed expectations have been revised higher, especially for February and March. Refinancing activity is expected to pick up in response to the dramatic drop in mortgage rates. Speeds are projected to increase about 2% overall in 4.5s through 6.5s in January with the greatest gains in the 2007 and 2006 vintages. For example, 2007s are projected to be 13% higher than December, while 2006s are expected to be up 4%. Other coupons and vintages are expected to be about 2% slower on average.
Speeds are projected to surge in February by 34% led by 2007 vintages, which are estimated to be up 45% on average. Meanwhile, 2006s are expected to average 37% higher, while the remainder of the coupons and vintages are projected to increase 30% from January's levels. March speeds are expected to increase further by 29% from the previous month.
Prepayment risk has picked up with the declines in interest rates (see story p. 17). Barclays Capital analysts estimated that about 73% of the market has at least 25 basis points of refinancing incentive. Although this might mean some pickup in refinancing should be expected, Barclays analysts noted that the lower HPA and tighter credit standards will dampen prepayments relative to previous refinance events.
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