Mortgage-backed securities market participants may have been twiddling their thumbs last week, quietly closing down shop or tidying up their balance sheets in preparation for Y2K. But this apparent tranquility belies an excited anticipation from observers reflecting an expected strong showing for both residential and commercial MBS as they emerge right out of the gate on Jan. 3.
Mortgage spread product will make a comeback in early 2000, sources say, and January should be a fairly strong month, building upon a bullish spread outlook at year-end and excellent technicals for the sector in general, MBS market observers say.
While experts are predicting that year-2000 residential MBS production will be down by 40% as compared to cumulative 1999 production, a strong economy and a virtually non-existent refinancing component bodes well for spread product, and the market will maintain its characteristic yield advantage, outperforming both Treasurys and corporates.
"The economy is so strong that you're going to see more construction and development," said Michael Hoeh, head portfolio manager at Dreyfus Corp. "Though there was a lack of supply in December and a lot of investors, this will be great for spread product, and this quiet atmosphere will change rather drastically come Jan. 3."
"If rates continue to go up, mortgages will outperform Treasurys and corporates, as it has this year, and so that yield advantage is still there," added an MBS trader. "In that regard, people are going to have to own the sector. If nothing else, there is this supply-demand imbalance, where there is more demand than what is being issued. All the big agencies and other organizations that have to own mortgage product will have a difficult time finding product, which will drive spreads tighter."
It is clear that the MBS market will grow - but at a much slower rate than in 1999. Just last week, Fannie Mae and Freddie Mac told their equity investors that their portfolio growth is going to be slower, meaning that the GSE's growth targets will be reduced for 2000.
However, the outlook still remains positive. Mortgage technicals remain very strong, as does the prepayment environment, says Dale Westhoff, managing director of MBS at Bear, Stearns & Co. "There is a whole anticipation for bank demand and the full gamut of investors will be back in the market come first quarter."
More IO Deals, CBOs To Come
As market players size up the previous year and contemplate which innovative structures or deals will foreshadow a future trend, two particular types of deals come to mind: Countrywide Home Loans' interest-only strip securitization of its Fannie Mae excess servicing portfolio, and an expected deluge of mortgage collateralized bond obligations.
There is no doubt that Bear Stearns' Countrywide deal turned heads this past November; the transaction, which was backed by 242,000 loans, brought to the fore a potential to limit investors' prepayment risks and highlighted never-before-seen insights into weighted average coupon dispersion data for Fannie Mae pools.
"We will see other IO deals," Westhoff said. "There will be more IO-like transactions because it is a good environment for that type of bond, and there is increasing demand for that kind of cash flow."
Additionally, a slew of mortgage CBOs will be hitting the market in January, sources say, as rating agencies change their restrictions on what can be included in them.
"There is a lot of demand for this sort of triple-B type of paper, whether it is residential, commercial or asset-backed," Dreyfus' Hoeh said. "All of these mortgage CBOs coming to the market in January will be a big positive for spread product."
The rating agencies have recently changed their underwriting guidelines for some of these transactions, giving more credit for diversification. In an upcoming Warburg Dillon Read mortgage CBO transaction, Moody's Investors Service and Standard and Poor's Ratings Services have stepped in to take part in a type of deal that has usually been handled by Fitch IBCA.
"This reflects that Moody's has gotten more aggressive in terms of getting involved in that marketplace," said the head of one MBS desk. "But now there is a certain comfort level among investors in real estate CBOs that such transactions are being rated by Moody's."
The Warburg deal will apparently allow for several different types of asset classes, including ABS and corporate bonds. Other deals from hedge funds Ellington Capital, Beacon Hill and Clinton Group are also expected to price in the first quarter.
CMBS Off And Running In 2000
Commercial mortgage-backed securities players are generally expecting a decent amount of new-year supply - 25% of which to show up within the first quarter.
"There is demand enough to take the bonds down without causing an appreciable widening of spreads," said Jeff Sturdevant, a CMBS trader at Salomon Smith Barney. "We expect this year to go very well versus comparable spread product, with a good amount of supply in the first quarter."
Spreads are said to be leaving off very strong at year-end 1999. Sources say that spread levels are close to where they were back in May, when the First Union conduit priced at 103 basis points over Treasurys. Last year showed a tremendous tightening between January and May, and then a significant widening, hitting its nadir in early August. And since then, spreads have tightened in once again.
"Swaps are now at 79, so if we keep those inside of 80, I think that would be pretty good," Sturdevant added. "We are going out on a good note."
Among other predictions for 2000, many people think there will be more international CMBS as part of the total CMBS package, as compared to years past.
"There are good retail sales, and we are expecting the economy to stay strong, at least through the first half of the year," said the head of a Wall Street CMBS desk. "This will keep sales up and allow retail to do reasonably well in terms of proceeds."
J.P. Morgan will be first out of the CMBS gate, as they are preparing to put the reds out on a new $800 million conduit (See Market story, page 4).