Supply finally hit the mortgage market last week with originators bringing over $20 billion on the significant backup in Treasurys.
The supply was split roughly 80/20 between 30-year and 15-year MBS. Within the 30-year sector, origination was primarily in 5.5% and 6% coupons, and in 5% and 5.5% for 15-years.
Despite the supply over the Wednesday-to-Wednesday period, spreads actually tightened. For example, in 30-year Fannie Mae's, 5.5s moved in 23 basis points, 6s were firmer by seven, and 6.5s and 7s were tighter by three basis points. In dwarfs, spreads moved in 12 basis points on average for 5% through 6.5% coupons.
While the nearly 50 basis point surge in 10-year Treasurys helped spreads, declining volatility, as well as very strong investor demand contributed. Money managers, hedge funds, banks and CMOs were actively taking advantage of cheaper prices and a favorable technical outlook.
Speaking of technicals...
While near-term daily supply is predicted to be heavy, net issuance is actually declining. The fixed-rate agency mortgage market shrank by nearly $11 billion in the third quarter ,according to JPMorgan Securities researchers. They attribute this to four factors: (1) the lag between prepayments and new securitization; (2) a high level of ARM share; (3) mortgage banks retaining a larger fraction of refinanced loans; and (4) a slowing in the housing market. Analysts expect some of these issues will reverse and lead to positive net issuance in the next six months. Still, they predict that a slowdown in the rate of home price appreciation will limit growth in fixed-rate issuance to under $50 billion per year.
More on that theme was discussed in Deutsche Bank's Fixed Income Weekly. Researchers reported that in August, there was net buying of $37 billion, but only $17 billion in MBS was created, followed by just $13 billion in September.
The bottom line is that MBS technicals continue to be strong. Supply has been less than expected, and at the same time there is strong demand from banks, money managers, and even the GSEs. "Risk aversion will keep investors in MBS," said Deutsche Bank analysts. "Combined with attractive financing in 30-year 5.5s and 6s, this is a recipe for good mortgage performance near-term."
But watch out
for extension risk!
According to a recent report from RBS Greenwich Capital, researchers said in an up 50 basis point scenario, the 30-year Fannie Mae universe would extend from a duration of 1.6 to 2.6. In a Goldman Sachs report, analysts recommend investors prepare for an extension scenario. They state "at current levels, extension risk is much higher than the risk of a shortening in durations." Goldman suggests seasoned pass-throughs, 15-year MBS, and PACs. They note that many of these securities are cheap versus collateral, with OAS pickups of 10 basis points to 25 basis points.
Refis dip slightly as mortgage rates jump
For the week ending Oct. 11, the Mortgage Bankers Association (MBA) reported that its Refi Index fell 2% to 6794. Despite the decline, this is the third straight week the index has been above 6000. Further, the index has been over 5000 for 10 of the last 11 weeks. Purchases also fell 3% last week to 342. Refinancing activity represented 78% of total applications compared to 77.9% in the previous week. This is just shy of the record 78.4% hit in November 2001. The share of ARM activity decreased to 12.8% from 13.4% the previous week.
Freddie Mac reported an increase in mortgage rates in its survey for the week ending Oct. 18. For instance, 30-year fixed mortgage rates jumped 17 basis points to 6.15%; 15-year fixed rate mortgages gained 22 basis points to 5.56%; and one-year ARM rates rose to 4.27% from 4.23%.
The increase in rates is expected to cause a reaction from fence sitters, which may keep the MBA's Refi Index firm. Those who have been waiting to refinance, though, may be in for further rate increases before a lender is able to get to them.
According to a report in last Wednesday's Wall Street Journal, borrowers have been having a difficult time getting through to swamped lenders. For example, the report noted that U.S. Bancorp is taking two to three days to return calls, while Countrywide Home Loans said telephone waiting times are up 50% to 75%. Also, the article noted that some lenders are taking 75 to 90 days to close a loan. All of these suggest that high prepayments should be prolonged. The table above gives the current prepayment outlook for the next three months for various coupons and vintages.