Before the Asian markets opened last Monday, it was announced that JPMorgan will be buying Bear Stearns for $2 per share. The Federal Reserve was also expected to cut the discount rates once again and to implement a new lending facility for the large investment banks to secure short-term loans.
The news served as a balm for MBS investors, resulting in the MBS sector tightening steadily throughout last Monday's session. The day saw very limited selling, with originators bringing less than $1 billion in supply, which was spread between 4.5s through 5.5s. There was active buying from servicers, hedge funds, money managers and Asian investors, both outright and versus Treasurys and swaps, while banks were two-way.
Mortgages' strength carried into Tuesday's session, partly based on news that the Office of Federal Housing Enterprise Oversight was meeting with both GSEs to discuss a reduction in their capital surplus. This brought in good buying from the real money contingent, which offset the heavy originator selling - $2 billion - after Treasurys sold off as equities rallied sharply following better-than-expected earnings results from Lehman Brothers and Goldman Sachs. Activity slowed down as expected as participants waited for the Federal Open Market Committee's statement.
The Fed's decision was to cut the funds rate by 75 basis points to 2.25% and the discount rate by 75 basis points to 2.5%. There was some brief disappointment among various market participants that it wasn't 100 basis points, but odds currently remain very high that the Fed will cut rates another 50 basis points on April 30. The statement noted that downside risks to growth still remain. "Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters," the Committee also said.
After the Fed's announcement, Treasurys sold off even further as equities rallied sharply. This encouraged profit taking as well as additional originator selling, which pulled spreads wider by close.
In other sectors, specified pools continued to lag in the early part of the week on better selling related to balance sheet constraints. The GNMA/FNMA swap was also pressured on the improved confidence inspired by the weekend's Fed action. This also contributed to 15s underperforming 30s.
Mortgages have rallied back sharply in the past week or so, courtesy of all the recent Fed interventions, including the creation of the term securities lending facility, or TSLF. Month-to-date through March 17, Lehman's MBS Index was underperforming Treasurys by just three basis points (now down just 95 basis points year-to-date). This compares with a negative 199 basis point month-to-date performance as of March 6. MBS are outperforming their various cross sectors both month-to-date and year-to-date: ABS (negative 48/negative 519 basis points), CMBS (negative 464/1,417 basis points) and U.S. credit (negative 241/negative 502 basis points).
Mortgage Outlook
MBS analysts' tone last week was neutral to negative. For example, Lehman analysts said they were holding to their neutral position on mortgages. The bank said that while the Fed's announcement alleviates concerns about financing, there remains a substantial supply/demand imbalance in MBS. Citigroup Global Markets analysts also remained neutral. They mentioned the heavy supply risks in the market. In addition, they didn't expect repo haircuts to improve much because of the creation of the TSLF. They said that the purpose of the haircut is to provide protection against adverse price movement - which many tend to associate more with credit risk - but it also provides protection against interest rate and spread risk. Given the elevated market volatility, analysts did not expect the program to alleviate the latter. "Overall, the TSLF will be relatively ineffective in repairing the agency MBS market," Citigroup analysts said.
JPMorgan Securities analysts stayed negative on the mortgage/swap basis. They were concerned over the potential "next stage" of dealer deleveraging, which could force spreads to trend even wider. The analysts also pointed out that the TSLF and FHA-related government rescue proposals do not address the balance sheet shortage in the system overall.
Prepayment Expectations
Prior to the February prepayment news, consensus was calling for speeds to increase about 13% in March. Following a larger-than-expected increase in speeds in February, partly in response to a rush of closings before the March 1 fee increases from the GSEs, prepayments are now projected to be 5% lower on average on 4.5s through 6.5s. The largest percentage declines are expected in 2006 vintages and also in 5% and 5.5% coupons.
Other factors contributing to the slowing are higher mortgage rates in February versus January - averaging 5.92% versus 5.76%. The 16-basis-point average increase, however, masks the nominal increase in mortgage rates over the period Jan. 25 through Feb. 22 when the 30-year mortgage rate hit a multi-year low of 5.48% and then steadily climbed to 6.24%, a 76-basis-point gain. Similarly, the Mortgage Bankers Association's Refinance Index averaged 12% lower in February versus January. However, from the low-to-high move in mortgage rates, the index plummeted 108% from 5104 to 2459.
Current projections are for speeds to slow around 7% to 10% in April and by around 5% in May. Higher mortgage rates, affected in part by the increased fees, are expected to offset the higher day count. Traditionally, seasonals pick up at this time, although it is expected to be much less compared with previous periods given the market environment.
"The selling season, which we believe starts in mid-January, has been weak for the third year in a row," Toll Brothers CEO Robert Toll recently said.
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