The market got right down to business as participants returned from their long Thanksgiving breaks. In the first two and a half days of trading, Treasurys were whipped sharply higher on a strong flight to quality and then retraced most of that on Tuesday and Wednesday morning as it was unwound. On Monday, the bid was instigated by a report from Goldman Sachs that said it expects HSBC will have to take another $12 billion in write-downs, as well as, news that Sen. Charles Schumer had sent a letter to the FHLB regarding its exposure to Countrywide Financial.
Volume in mortgages was above normal in two-way flows on Monday and Tuesday. On Monday's sharp rally, servicers were adding duration by actively buying 5.5s outright and moving down in coupon from 6s into 5.5s. Other investors were generally better sellers, with particular note made of bank selling in 5s as prices improved. Tuesday saw overall better selling, especially from servicers who were now shedding duration by moving up in coupon as the market sold off or by selling outright. Mid week was finally seeing a more supportive tone in the market with prices actually higher while Treasurys were lower and with volume taking a breather after holding sharply higher in the previous two sessions. Getting the market off to a positive start on Wednesday was decent Asian buying, focused in gold futures, as well as domestic fast money. Spreads were substantially tighter heading into mid day on Wednesday.
In the first two days of the week, originator selling was running at less than $1 billion per day; however, it ramped up sharply on Wednesday to nearly $2 billion. Supply remains focused in 5.5s and 6s. For the month, mortgage performance has been dire. According to Lehman Brothers, month to date through Nov. 23, the MBS index is down 143 basis points. Meanwhile, the ABS index is lagging Treasurys by 147 basis points, the CMBS index by 346 basis points and corporates by 212 basis points.
Update on Housing/Subprime/Credit
Existing home sales slipped 1.2% in October to an annual rate of 4.97 million. This is the lowest level since the series began in 1999. Inventories increased to a 10.8 months' supply from 10.4 months in September. Home prices were down 5.1% to $207,000 in October from $218,900 in October 2006. Despite the small percentage decline, most economists are not ready to suggest that housing is stabilizing, especially with the ongoing subprime write-downs, weak housing and tighter credit. Wells Fargo reported it would take a $1.4 billion loss in the fourth quarter related to home equity loans. As it warned following release of its third-quarter earnings, Freddie Mac announced on Tuesday that it had cut its dividend rate 50%. On the day before, UBS issued a report cutting both FNMA and Freddie Mac stock to neutral from buy. UBS expects slower earnings growth due to higher credit costs from higher loss reserves and negative mark-to-market on certain assets.
According to S&P/Case-Shiller, the 20-city index home price index declined by 4.9% from September 2006 to September 2007. In the 10-city index, prices were off 4.5% from a year earlier, better than the 5.0% year-ago drop shown in the August index. For the quarter, the index fell 1.7%, which was the largest quarterly decline in the index's 21-year history. According to press reports, in a teleconference Robert Shiller said the futures market for the S&P/Case-Shiller Composite Index indicates home prices will decline another 5% in 2008.
Prepayment Outlook
Current estimates suggest prepayments on Fannie Mae 30-years will decline about 10% to 11% in November. Influencing speeds are a lower number of collection days-20 versus 22 last month-and slowing seasonals, not to mention the weak housing market and tighter underwriting standards. Looking out to December and January, speeds currently are predicted to slow around 7%-8% for both months. Market participants anticipate pay-downs around $30 billion or slightly less.
Based on the current conditions in the market-tighter credit standards, reduced lending capacity, home price depreciation-it's no surprise that the outlook for speeds in 2008 is slow. In JPMorgan's 2008 outlook, the bank notes that prepayments already match the 1999/2000 experience, and with the negative housing outlook, they are at risk of further slowing to perhaps levels seen in 1994 and 1995. The bank adds that the 2006 and 2007 vintages are particularly vulnerable as they have limited equity built up. Analysts also cite the following factors as limiting the ability of these borrowers to refinance-even though they are in-the-money. These factors are: (1) Lending capacity has been reduced as over 100 lenders have either curtailed or exited the business; (2) ARM rates are not especially attractive versus fixed rates, despite the steeper curve, and in addition borrowers now must qualify at the fully indexed rate; (3) There are tighter lending restrictions from the GSEs in states with HPD; and (4) There are higher borrowing costs due to higher fee structures from the agencies and higher subordination levels from the ratings agencies.
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