Wednesday's ADP National Employment report brought havoc to the market in what was expected to be a quiet, but supportive week for mortgages bounded by the Fourth of July holiday and non-farm payrolls. Concerns that Friday's employment report would be much stronger than expected sent the bond market sharply lower with the 10-year yield rising seven basis points on Wednesday from Monday's close. Thomson Finanacial/IFR economists, however, expect non-farm payrolls to be up 165,000, while the median is at 175,000. The ADP report suggests a print of 368,000 in private jobs.
The backup brought out active selling in the mortgage market from both real and fast money midweek with movement up-in-coupon in both 30s and 15s. In particular, strong bank selling was noted which is raising concerns about future large bank support for MBS. Also negatively impacting mortgages was the uptick in volaltility. The market was calmer on Thursday morning with a slightly supportive tone, which was drawing in slightly better buying from real money.
Near-term events - payrolls, paydowns, and roll activity - tend to provide a short-term benefit for mortgages. This could be potentially strengthened if Friday's employment report brings a relief rally. There is expectation by some that even if the number is stronger than consensus forecasts, the market will rally if it is significantly below what the ADP report predicts.
The longer-term outlook, however, is becoming a bit cloudy once again. Positives previously discussed by analysts include the technicals, with overseas investors expected to be better buyers when the Federal Reserve pauses, the potential decline in volatility with more clarity from the Fed, and steady buying from large banks. However, David Montano, a strategic principal trader at JPMorgan Securities, in a report released last week discussed the potential for little improvement in mortgage performance over the next couple of months. Historically, the third quarter has not been strong for mortgages, he notes, as real money buying tends to be weighted towards the beginning of a year. He also is concerned about ongoing support from large banks as the deposit base has not had the strong growth seen in recent years. "This is a number that should be closely watched, as a drop in deposits would lead to a rapid increase in bank funding costs," he warns.
The latest data from the Federal Reserve showed a $44.5 billion decline in deposits at large banks for the week ending June 21. Year-to-date, deposits on net are up $6.6 billion. At the same time, significant selling from banks is not expected as unrealized losses in the AFS portfolio are at a high of $21 billion. Rates would have to drop around 100 basis points for losses to be eliminated.
Mortgage application
activity rises 6% overall
Mortgage application rose in the last week of June despite the seven basis point increase in the 30-year mortgage rate to 6.78%. The Mortgage Bankers Association reported that the Refinance Index was up 5% to 1423.9 while the Purchase Index gained 6.5% to 414.2.
Overall, refinancing activity in June was down just slightly on average from May's level with the Refinance Index averaging 1436 versus 1444 previously. Purchase activity was slightly higher averaging 408 compared to 406. The 30-year mortgage rates also held fairly stable on average at 6.69% in June versus 6.61% in May. Despite the small pop in activity, expectations are for application activity to trend lower in the weeks ahead on the increase in mortgage rates and reduced attractiveness of ARMs.
Mortgage rates hold steady according to the FHLMC survey
For the week ending July 7, mortgage rates were little changed. According to Freddie Mac's weekly survey, 30-year fixed rate mortgages rose one basis point to 6.79%. With the 0.5 average fee, the no point rate is at about 6.92%. Mortgage rates are at their highest level since May 2002, and are up 117 basis points from a year ago.
In other rate programs, Freddie Mac reported 15-year fixed mortgage rates averaged 6.44% compared to 6.43% last week; 5/1 hybrids were unchanged at 6.39%; and one-year ARM rates also rose just one basis point to 5.83%. Freddie noted that one-year ARM rates have not been higher since the week ending June 8, 2001, when it averaged 5.85%. One-year rates are 150 basis points higher versus a year ago.
Incentive to refinance
In their monthly Short-Term Prepayment Estimates report, Bear Stearns Senior Managing Director Dale Westhoff notes that with the no-point 30-year mortgage rate at around 6.90%, less than 4% of the mortgage universe has an incentive to refinance. He adds that the average borrower has a sub-6% mortgage rate, and that 70% of the mortgage universe is concentrated in 5% and 5.5% coupons. "We now find that the average borrower holds a mortgage that is nearly 100 basis points below par," he notes. Not counting the "prehistoric" mortgage market of the 70s and early 80s, there has only been a brief four-week period in May 2000, when the overall market has been this far out of the money, he adds.
Regarding the implications of the housing market for prepayment speeds, Westhoff states that the decline in the MBA's Purchase Index - around 15% from 2004/2005 activity - implies a 15% decrease in speeds driven by housing turnover across all vintages and coupons. On the cash-out refinancing side, he observes that pre-2005 vintages have experienced significant equity build-up, allowing for short seasoning ramps and high baseline speeds on moderate discount and premium coupons. However, this isn't the case for post 2005 originations. As a result, Bear expects "the seasoning ramp to extend and baseline speeds to fall on MBS backed by these new originations." Going forward, analysts also believe cash-out refinancing activity will be focused more in the 6% and higher coupons, which make up only about 25% of the outstanding universe. As a result, prepayments through cash-out refinancings are predicted to decline significantly from 2005 levels.
Based on their analysis, they expect deep discounts will revert to 1999/2000 levels, while near par coupons are predicted to slow 30% from 2004/2005 levels, but remain faster than the 1999/2000 period.
Prepayment outlook
June prepayments are expected to be relatively flat in 5.5% coupons and lower, and slowing less than 5% in higher coupons. Offsetting favorable seasonals are slightly higher mortgage rates and slightly lower refinancing activity on average over the period influencing the report. JPMorgan estimates June paydowns to be just over $40 billion. The conventional reports were due last Friday, while it was the following Monday morning for GNMAs.
Looking ahead to July and August, speeds are forecast to drop about 10% in July on a lower day count, as 30-year mortgage rates and refinancing activity held fairly steady on average in June compared to May. Speeds are anticipated to recover in August on a higher day count.
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