The final quarter of 2011 got underway with the return of the Fed which began reinvesting its paydowns from Agency MBS and debentures back into the MBS sector. 

Investors were anticipating strong supply-demand dynamics to be evident immediately; however, that wasn't the case.  In fact, beginning October 3 through October 5, the Fed bought $3.95 billion in 3.5% and 4.0% coupons, while mortgage banker supply totaled nearly $7 billion.

Looked at over a longer term, the supply/demand dynamic is much improved; however, with Fed buying an average of $1.25 billion per day over the near term, while mortgage banker selling is running at over $2.1 billion per day on average now, the private sector still has to do its share - and that wasn't always the case last week.

For the most part, hedge funds, real money, money managers and others were two-way.  A strong flight to safety bid on Monday (courtesy of Greece and Europe) encouraged profit-taking in the basis, while a sell-off on Tuesday and Wednesday as investors turned less risk averse (again mostly European related) led to more profit taking or sidelined investors as originator supply ramped up; although at periodic wides, investors did take advantage of the cheapening. 

While the sell-off continued on Thursday, the 10-year note yield heading towards 2.0% drew in better support with the Fed, hedge funds, money managers and real money more than offsetting the $2.0 billion in supply.  Interest focused in 3.5s and 4.0s, until the prepay news was released which reported a sizeable increase particularly in 4.0% coupons, as well as, in 4.5%s.  

Real money and fast money heavily sold the cuspy coupons beginning late Thursday afternoon through Friday with flows moving mostly into 3.5s, but also into super premiums where speeds slowed more than expected.    

While fuller coupons were doing better on Friday, they had their own issues to deal with all week: headline risk. It's been widely disseminated that tweaks to HARP involving removal of the 125% LTV cap, reduction in LLPAs, and even extension of the HARP date to selected borrowers would have a limited impact on speeds.

The biggest impact always came back to "reps and warranties." Just a few weeks ago, this type of change was thought to have a very low chance of happening; however, recent reports suggest the FHFA is considering some selective waivers.

Treasury Secretary Timothy Geithner told the Senate Banking Committee this week that he expected the FHFA to provide details in the next couple of weeks. As a result, liquidity remained thin in higher coupons with better profit taking, particularly noted in 5.5s and 6s.

In other mortgage related activity, dollar rolls were pressured lower as investors rolled to November ahead of Class A (30yr conventionals) 48-hour day on October 11. Specified pool trading was active on a combination of originator BWICs totaling over $16 billion, while investors actively sought out call-protected paper - mostly low loan balance.  GN/FNs were mostly higher, while 15/30s were higher in the latter half of the week as the curve steepened sharply.

Of note regarding Ginnies and 15s was better than expected buying from the Fed. These two sectors had been adversely impacted, in part, as most of the Fed's buying was expected to be concentrated in 30-year conventionals.

According to a report from UBS, "the Fed surprised the market by buying 15s and Ginnies, in addition to conventional 30s." They said it appeared that the Fed's purchases were roughly mirroring what originators were selling.  If this continues to be the case, it "should result in less inter-sector relative value dislocations," they concluded.   

MBS volume over the week through Thursday averaged 122% compared to 111% last week. Excess return versus Treasuries on Barclays Capital's MBS Index was -20 basis points with the sector outperforming CMBS (-88bps) and Corporates (-53bps) and just slightly lagging ABS (-14bps). The 30yr Current Coupon yield increased to 3.18% from 3.07% as of the end of September with the spread to 10yr notes widening to +119bps from +114 and to +98bps from +95 versus 10yr swaps.   

Prepayment Review and Outlook

Overall, eMBS reported speeds on FNMA MBS jumped 30.6% to 22.6 CPR, Freddies 31.2% to 22.3 CPR, while Ginnies rose 20.9% to 13.9 CPR.  Gross issuance totaled $88.0 billion; paydowns amounted to $104.9 billion, leaving net issuance at -$16.9 billion. Net issuance for the GSEs was a negative $25.8 billion combined, while Ginnies remained positive at $8.9 billion. 

Heading into the September report, the outlook for speeds in October (reported in November) has been projected to increase less than 5% overall in Thomson Reuters' sample. Factors influencing activity include a lower day count at 20 from 21, as well as, lower refinancing activity with the MBA's Refi Index averaging 4% lower in September versus August despite mortgage rates in Freddie Mac's survey averaging 4.08%, down 18 basis points.   



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