Cataclysmic changes occurred in the financial landscape last week. Lehman Brothers failed to find a buyer and declared Chapter 11, Merrill Lynch was bought for $50 billion by Bank of America in a total stock transaction and American International Group (AIG) was taken over by the Fed in an $85 billion bailout.
When 2008 opened, there were five major Wall Street brokers: Bear Stearns, Goldman Sachs, Lehman, Merrill Lynch and Morgan Stanley. Two are left now - but for how long? While Morgan Stanley reported better-than-expected third-quarter earnings, there were reports at press time that it was weighing the possibility of merging with a bank.
Despite the resolution of AIG on Tuesday evening, Wednesday's session had a strong flight to quality going.
Meanwhile, global central banks were busy pumping liquidity into the markets to help lower overnight lending rates in response to this latest turmoil. On Monday, the Federal Reserve injected $70 billion in reserves and another $50 billion on Tuesday.
The week also included a Federal Open Market Committee meeting on Tuesday. Given the weekend events, odds had increased on Monday that the Fed would cut the funds rate by 25 basis points. However, the Fed instead held rates unchanged in a unanimous decision.
"Strains in financial markets have increased significantly, and labor markets have weakened further. Economic growth appears to have slowed recently, partly reflecting a softening of household spending. Tight credit conditions, the ongoing housing contraction and some slowing in export growth are likely to weigh on economic growth over the next few quarters.
Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth," the Fed's statement said. "Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain."
MBS volume was running above normal through mid-week in two-way flows. Monday experienced more than $3 billion in convexity-related buying from servicers, along with a like amount from money managers and hedge funds. Real money was a heavy seller, as were originators with more than $2.5 billion in supply. Spreads closed wider to the curve by six and nine ticks in 5s and 5.5s, respectively, and by 14 and 17 in 6s and 6.5s. Versus swaps, spreads ranged from four weaker in 5s to 15 in 6.5s.
On Tuesday, spreads versus the curve ended wider by 19 ticks on 5s, nine on 5.5s, three on 6s and two on 6.5s. Versus swaps, spreads ranged from 17 ticks weaker on 5s to one on 6.5s. Servicers were heavy sellers in the early going, sending spreads sharply wider, but money managers and hedge funds stepped up to pull spreads off their wides. Originator supply was heavy again at close to $3 billion.
The mortgage picture was not pretty on Wednesday as the markets remained gripped with fear. At mid-day, mortgages were wider to the curve by 27 and 19 ticks in 5s and 5.5s and by 13 ticks in 6s and 6.5s. Up-in-coupon was outperforming on Tuesday and Wednesday given its recent underperformance as investors, particularly servicers, aggressively added duration as mortgage rates fell.
In other mortgage-related news, overseas investors were better sellers, 15s outperformed 30s, specified pools were mixed with some profit taking reported and GNMA/FNMAs were lower. Dollar rolls were weaker on the increased funding costs. Supply through mid-week averaged between $2.5 billion and $3 billion per day and consisted of 75% in 5% coupons and 25% in 5.5% coupons.
Mortgages remained in positive territory for September last week but were off their recent performance gains. For example, month-to-date through Sept. 11, Lehman's MBS Index had outperformed Treasuries by 111 basis points but was ahead by just 38 basis points through Sept. 16. Mortgages, however, continued to substantially outperform competing sectors: ABS at negative 16 basis points, CMBS at negative 272 basis points and corporates at negative 360 basis points.
Mortgage Applications Surge
Refinancing activity surged - as was expected - in response to the dramatic decline in mortgage rates following the government takeover of the GSEs. For the week ending Sept. 12, the Refinance Index jumped 88.1% to 2300, its highest level since early May. The Purchase Index rose just 2.8% to 342.8.
The Mortgage Bankers Association reported that the 30-year fixed contract rate averaged 5.82%, down 24 basis points from the previous report. The one-year ARM rate slipped five basis points to 6.95%.
As a percent of total applications, refinancing share was 51.6%, up from 36.3%. The last time refinancing share was above 50% was in April. ARM share fell to 4% from 6.4%.
Further gains, particularly in refinancing activity, are expected to continue. FTN Financial said in a report that about 42% of the outstanding 30-year agency MBS universe has a 50-basis-point incentive to refinance, and 14% have a 100% incentive. This is up tremendously since July, when less than 10% of the mortgage universe had an incentive to refinance. Street expectations are for the Refinance Index to soar above 3000 and possibly up to 5000 in the weeks ahead.
Current conditions in the market are not favorable for mortgage performance in the near term. Liquidity is thin, balance sheets are constrained (particularly with quarter end approaching) and funding costs have risen sharply. One positive note for Agency MBS is that it at least provides better liquidity than other sectors of the mortgage market.
UBS analysts moved to a mortgage overweight last week based on the recent cheapening and expectations that volatility should drop following the resolution of Lehman, Merrill and AIG.
Prepayment Outlook
Speeds in September are projected to be lower by 5% in Fannies and 2% in GNMAs. Contributing to the decline are lower refinancing activity in August as well as higher mortgage rates. The Refinance Index averaged 1052, down 18% from July's average. At the same time, the 30-year fixed mortgage rate averaged 6.48%, off five basis points from July's average. Day count holds steady in September at 21 days.
The 30-year fixed mortgage rates have dropped more than 40 basis points since the GSE takeover. As a result, speeds are projected to surge 25% to over 30% in October, with the largest percentage gains seen in 2007 vintages. Speeds currently are expected to turn modestly lower in November on slower seasonals and five less collection days compared with October.
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