As 2009 began, the government was scrambling to put together programs to keep financial institutions afloat, provide liquidity to the frozen credit markets, keep people in their homes and develop stimulus packages to prevent the economy from sinking into a depression.

The Federal Reserve initiated its program, which started on Jan. 5, to buy $500 billion in MBS by the end of 2009. This came along with various other initiatives: Congress passed a $787 billion stimulus package in February, the Fed extended and expanded its different liquidity facilities and the Obama administration released its Homeowner Affordability and Stability Plan designed to help between seven and nine million families restructure or refinance their loans to avoid foreclosure.

In March, the Federal Open Market Committee (FOMC) announced it would increase its buying of agency MBS to $1.25 trillion and agency debentures to $200 billion from $100 billion to help the housing market. In addition, it said it would purchase up to $300 billion of longer-term Treasury securities over a six-month period to help lower mortgage rates.

In August, the Treasury Department began reporting servicers' progress on loan modifications to pressure them into increasing modification activity. In late September, the FOMC announced it would extend its MBS buying through the first quarter of 2010 and slow its pace of buying. In early November, the first-time homebuyers tax credit, which expired on Nov. 1, was extended through April 30, 2010, and expanded to cover current homeowners who are "moving up" into another primary residence. Finally, as the year closed out, the House of Representatives passed a wide-ranging Financial Regulatory Reform bill by a vote of 223-202. No Republicans voted for the bill.

The various programs did stave off a depression and the recession was declared over in the summer. However, their impact on the housing market was mixed. Delinquencies and foreclosures remained at record levels in the third quarter, according to the Mortgage Bankers Association's (MBA) quarterly survey. But home price declines slowed, helped by record high affordability and the homebuyers tax credit. In January, year-over-year declines on the Standard & Poor's 20-City Composite were negative 19% but were "improved" to negative 7.3% by October.

While the Fed's MBS buying brought the 30-year fixed mortgage rates to record low levels, refinancing response was muted as credit standards remained very tight. In January, following the start of the Fed's buying, the MBA's Refinance Index hit its high for the year of 7414 with 30-year mortgage rates at 5.01%.

In April, when rates fell to a record low of 4.78%, the index stood at 6813, and in early December with 30-year rates at a new record low of 4.71%, the Refinance Index reported at 3186. In addition to the tight credit standards that limited refinancing activity, there is a reduced universe of borrowers with an incentive to refinance as many refinanced earlier in the year. The government's program to help three to four million people modify their loans has had limited success with 31,382 loans reaching "permanent modification" status by the end of November.

The refinance wave of 2009 became the refinance dud of 2009. Prepayment speeds on FNMA and FHLMC Golds 30-year fixed-rate MBS were at 15 CPR as of November compared with 9 CPR in December 2008 and GNMAs at 22 CPR from 16.

At their fastest, speeds were in the mid-20 CPR in late spring. Estimates offered at the beginning of the year on 2007 vintage FNMAs estimated that at a 4.5% mortgage rate and relaxed underwriting, speeds on 5s through 6.5s could reach around 60 CPR and 7s 50 CPR. Speeds on this vintage at their highest were between 27 and 34 CPR for the various coupons.

The agency MBS market recorded a strong performance year as the Fed buying substantially overwhelmed the supply. Through Dec. 23, the Fed had bought $1.102 trillion, while year-to-date gross issuance through November totaled $1.53 trillion with net issuance of nearly $500 billion.

As the numbers implied, the mortgage market was all about technicals in 2009 and not fundamentals. Valuations were relatively rich through much of the year which led other major investors of the sector to essentially develop a day-trading mentality, with buying on lower dollar prices and selling on higher ones.

Year-to-date through Dec. 28, Barclays Capital's MBS Index had an excess return of 485 basis points over Treasurys compared with negative 214 basis points in 2008 and negative 177 basis points in 2007.

The 30-year current coupon spread versus 10-year swaps and 10-year Treasurys opened the year, at 127 and 165 basis points, respectively. They had tightened to 58 and 74 basis points, respectively, as of Dec. 28. They reached their tightest levels of 51 and 65 basis points, respectively, in the latter half of May.

Future Market Fundamentals

With the Fed's exit from the market by the end of March 2010, fundamentals are expected to return to the market. However, the technical picture appears better than originally anticipated with the Fed gone. Previously, there were concerns of GSE selling as they absorbed more than $200 billion in delinquent loans onto their portfolio with the adoption of FAS 166/167 on Jan. 1, along with the requirement to reduce their retained portfolio by 10% by yearend 2010.

On Christmas Eve, however, the Treasury Department announced amendments to the terms of the Preferred Stock Purchase Agreements with the GSEs. Originally, the terms provided up to $200 billion for each in funding as needed. However, the agreement was amended to what was "necessary to accommodate any cumulative reduction in net worth over the next three years." The Treasury said its reason for doing so was to "leave no uncertainty" about the government's commitment to help the housing market through this crisis.

In addition, the Treasury provided increased flexibility to the GSEs' requirement to reduce their retained portfolios by 10% beginning in 2010. According to the Treasury, "The portfolio reduction requirement for 2010 and after will be applied to the maximum allowable size of the portfolios - or $900 billion per institution - rather than the actual size of the portfolio at the end of 2009." Based on this, the GSEs' portfolios at the end of 2010 could be $810 billion versus less than $700 billion based on their most recent ending balances.

Bank of America Merrill Lynch analysts said they don't expect the GSEs to be active buyers in their portfolios, but that this change "should reduce the selling pressure at the GSEs" as well as provide room to buyout delinquent and modified loans. The latter, however, adds to prepayment risk in higher coupons.

Net supply for 2010 is currently estimated at $320 billion. The Fed still has $130 billion in purchasing power through 1Q10, leaving around $200 billion to be absorbed by banks, money managers, overseas and others. Analysts, on average, estimated bank buying to total $165 billion, which will be helped by the steep yield curve and limited loan demand, while overseas investors are anticipated to take $100 billion as risk aversion diminishes.

Money managers are currently short mortgages and will require some level of widening in spreads to entice them away from competitive sectors such as corporates and non-agencies. JPMorgan Securities analysts calculated that option adjusted spreads would need to widen by 30 to 40 basis points to be competitive with other sectors. Previous estimates have estimated that the Fed's exit from the market would cause a knee-jerk widening of 30 to 40 basis points.

Prepayment Outlook

In the past, low mortgage rate levels led to strong refinancing waves. However, that wasn't the case in 2009 despite rates hitting record lows, and it isn't likely in 2010.

The housing market is expected to remain weak with further declines in home prices currently estimated at around 10% nationwide, tight underwriting standards, slow economic growth and high unemployment levels high. As a result, voluntary prepayments are projected to remain slow next year. The Treasury's announcement, however, increases the prospects of large-scale voluntary buyouts, Credit Suisse analysts said.

Meanwhile, involuntary prepayments are anticipated to increase substantially as a result of record high delinquency levels, the adoption of FAS 166/167 by the GSEs and increased loan modifications.

JPMorgan analysts expect buyout activity related to loan modifications to peak in the first quarter. Based on Home Affordable Modification Program, or HAMP, modifications started and that should be eligible for buyout in January and February, analysts said speeds on 6s could top 30 CPR, 6.5s could see high 30s to 40 CPR, and 7s the low 40 CPR area.

The GSEs' adoption of FAS 166/167 beginning Jan. 1 has increased the risk of buyouts related to delinquencies. Deutsche Bank Securities analysts said if Freddie Mac bought out all its seriously delinquent loans in a single month, the one-month CPR would hit 77. Spreading it out over three months would result in a monthly speed of 37 CPR, in addition to current voluntary speeds.

Given the risks of buyouts, Street analysts recommended avoiding 2006-2007 vintage 6.5s and 7s as well as 6s.

GNMA speeds, voluntary and involuntary, have been faster than conventionals this year as a result of easier credit standards and active servicer buyouts.

In 2010, however, GNMA and FNMA differentials are expected to narrow, Barclays Capital analysts said. They noted that underwriting has tightened.

Additionally, there is a new rule on loan modifications that requires that the modified interest rate cannot be more than 50 basis points higher than the prevailing mortgage rate, which should reduce the incentive for servicers to buyout loans for modifications.

(c) 2010 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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