Although technicals in the mortgage market are still considered positive and the housing sector remains robust, MBS market participants are beginning to prepare for the eventuality of rising rates and the accompanying risks. The diminishing 30-year sector and growth in alternative affordability products are also noteworthy trends coming into the New Year. Aside from these, related issues such as FAS 133 and the recent GSE accounting woes remain in the foreground as 2005 rolls in.
Andrew Davidson, president of Andrew Davidson & Co., Inc., said that the market has been in a two-year holding pattern where rates stayed low. However, spreads have been tightening recently while risks have been increasing. Short-term rate increases, for instance, have made it harder and harder to maintain the income investors are earning on trades, which is only one of a multitude of effects on the market. Davidson noted, however, that the market has not yet reached the breaking point, but it has become more difficult to maintain stable price levels. Davidson said that home price appreciation continues to be the key to the mortgage market. If rates stay relatively low, the high level of home prices can be sustained. However, once rates rise, he expects either home price growth to dip or even stop.
Aside from rate increases, Davidson mentioned other existing risks to the market. One of them is the specter of the accounting rules - such as FAS 133. Because of these accounting-related issues, Davidson said it has been harder to execute strategies that involve derivatives. He added that he does not expect a near-term resolution to this problem.
There is also current controversy involving the GSEs, specifically Fannie Mae. Davidson said that the "spill over" effect to the mortgage market are the questions of how much of an active buyer would Fannie Mae and Freddie Mac be going forward, and what products make sense for them to purchase. He noted that the accounting issues relating to Fannie Mae are now before the Securities and Exchange Commission, which is expected to decide on whether the GSE would need an earnings restatement. If a restatement does happen, this might affect GSE activity in the mortgage market and serve to push legislation on GSE regulation. However, if a restatement were not necessary, this would call into question the SEC's and the Office of Federal Enterprise Oversight's credibility, but would give both Fannie Mae and Freddie Mac freer reign for growth. GSE regulation would still be an issue in any case, Davidson added.
Affordability products
With home price appreciation, so called affordability products' such as hybrid ARMs and IOs have emerged as compelling alternatives to fixed-rate product, and are expected to flourish more in 2005. Pushing this trend further are short-reset mortgages such as negative amortization loans, which are arguably more leveraged versions of interest-only adjustable- and fixed-rate loans. These loans have low teaser rates and payment caps, and minimum monthly payments that are typically less than even an IO payment would be.
Analysts said that these emergent mortgages are a product of significant home price appreciation, driving borrowers to manage their monthly mortgage payments. "The market is becoming more payment-sensitive than rate- sensitive," said an MBS analyst.
The analyst added that even with the flatter curve, demand for hybrid ARM products would likely remain. "The flattening that we've seen hasn't spilled into rates," noted the analyst, adding that significant flattening has to occur to snuff out appetite for ARMs. The 5/1 Jumbo ARM rate has to move three-quarters of a percent or higher to turn borrowers away from the product, which would require more of a curve flattening than people are anticipating, he said.
Aside from the growth in ARM product, the analyst also noted increased production in the subprime arena, and also expects continued growth in second lien and HELOC loans. He said that this probably suggests continued stagnation in conventional fixed-rate agency production. The only scenario that could cause a notable pickup in the fixed-rate sector is for the curve to flatten out significantly, pushing the ARM borrowers approaching their reset period into fixed-rate loans.
In a recent report by Countrywide Securities data suggested that the percentage of non-agency short-reset ARMs - mainly negative-amortization products - increased in November to roughly 22% of total prime production from about 3% in April. By contrast, the proportion of agency-eligible fixed-rate loan production dipped about 9% while the percentage of non-agency hybrid ARMs dropped about 6%. Additionally, while roughly 40% of both agency hybrids and short-reset ARMs were taken as purchase loans, 73% of non-agency hybrid ARMs were purchase loans.
The report concluded that the high purchase percentage of non-agency hybrid ARMs implies a degree of comfort with the product as a purchase vehicle by both borrowers and realtors. But it also noted that it is possible that realtors are not as comfortable marketing the short-reset products to homeowners as with hybrids because of unfamiliarity with the product's features. The lesser proportion of purchase mortgages in shorter-reset loans implies that these products are not being used as a purchase vehicle of last resort on a large scale but are being utilized mainly as a cash-flow management vehicle by borrowers. The relatively low proportion of nonconforming hybrids taken as refinancings could mean less fixed to ARM refinance activity, researchers added.
Investors look for carry and convexity
"I think the mortgage market is currently going through the time honored task of looking for good carry," said Chris Hanlon, director of mortgage-backed and government securities at Hartford Investment Management Co. Hanlon said that despite the current favorable market technicals, investors are starting to look at how they could withstand a widening trend if Treasurys move out of the current trading range. Hanlon said that there is more of a focus now - compared to most of 2004 - on FICO and seasoning as investors try to improve the characteristics and convexity of their portfolios. "I think people are starting to ask whether we are going to stay in this range," Hanlon added. For his part, Hanlon has not yet made any major changes to his portfolio strategy, but is sticking to sectors that offer better convexity such as low loan balance loans where, "the benefit of the trade has already been priced in."
Hanlon added that his firm is biased toward the up-in-coupon trade on the collateral side, given current Treasury rates and the flatter yield curve. This trade, he said, still provides pretty good carry and is currently rolling very well. In discounts, Hanlon suggests looking at structured collateral, which offer more stability, such as PACs. For instance, buying a 5% PAC is good protection versus unseasoned higher coupon PACs that paid faster than predicted in the last prepay report.
In terms of other market trends, Jumbo hybrid ARMs now comprise a higher percentage of recently originated mortgage portfolios, particularly in terms of CMO sequentials and short-listed PACs, Hanlon said, adding that, given credit issues involved, he tends to stay with the senior portion of deals. Additionally, Hanlon is looking at regions where housing appreciation is overdone, especially for pools with a large loan concentration in overheated markets.
As more and more people move into ARMs and IO product, the fixed-rate market has recently seen a decrease in origination recently. Hanlon said that because of this diminished volume there is relative value to be found in the 30-year sector and that speeds would still be kept in check if the curve flattens by the borrowers' inability to refinance an ARM into a 30-year loan given higher rates.
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