With MBS supply threatening to skyrocket - as estimated net issuance in mortgages could reach $200 billion to $250 billion per quarter going forward - analysts are less optimistic about the mortgage market.
"Over a slightly longer horizon, we are less sanguine around the prospects for the mortgage market," said Lehman Brothers analysts. "The big risk we see for the sector is from building supply pressures."
The figure of $200 billion to $250 billion a quarter for net issuance was derived from the current historically high level of the Mortgage Bankers Association (MBA) Purchase Index, which Lehman said is a good indicator of net supply. Bank demand is not sufficient to absorb this amount, and the GSEs need significant spread widening before they come in.
In looking at the actual impact that the expected supply might have, market participants should focus on net issuance and not the Refi Index nor gross issuance, said Lehman. Using the latter two as a basis gives the illusion that supply remains a non-issue considering refinancing activity is still 40% lower compared to peaks seen last year.
When it comes to supply and demand imbalances, Lehman said the important factor is net issuance, as a rise in issuance caused by paydowns can be readily met by reinvestment needs. Net issuance is the crucial factor because it has to be met with new demand. The best indicator of net issuance is the MBA Purchase Index, said analysts, who noted that this index has risen by roughly 30% year-over-year based fully on the number of applications. And if the rise in the loan size of the average purchase mortgage is considered, the increase is even more significant, at 50%.
Banks are not expected to be able to absorb this much supply. For one thing, the share of mortgages held by banks has dropped slightly in the past three years. Added to this, even in the most optimistic assumptions, analysts do not really expect bank demand for mortgages to move above $200 billion this year. For this level of supply to be absorbed, the GSEs need to come in and become net buyers of mortgages again. At the start of 2004, Lehman said that spreads needed to widen by 20 to 25 basis points to make sense for the GSEs to enter the market. However, with mortgages cheapening by five to 10 basis points since then, Lehman said that spreads need to widen another 10 to 15 basis points for the arbitrage to make economic sense for the GSEs.
In a separate report, Credit Suisse First Boston released its 30-year and 15-year Agency fixed-rate MBS net issuance predictions. The estimates are: $12 billion for March, $13 billion for April and $1 billion for May. These correspond to gross issuance numbers of $78 billion, $92 billion and $119 billion, respectively, and minus paydowns of $90 billion, $105 billion and $120 billion in these three months.
CSFB said that net issuance is the result of the following three factors: new home purchases, home price appreciation and higher LTV on purchases of existing homes, as well as cash-out refinancings. The firm noted that a rising Purchase Index does not automatically translate dollar-for-dollar into net new issuance. In terms of cash-out refinancings, analysts think that Freddie Mac's 2003 cash-out volume of $138.7 billion only accounts for the upper bracket of 2004 cash-out volume, especially considering that the level of refinancing activity is now half that of 2003's peak.