Mortgage market players considered the second quarter of 1999 to be a particularly rough period for the industry, as the direction of several of the fundamental technicals for mortgages - a lengthening of durations, a steepening of the yield curve and an increase in volatility - were all reading red.
"As you stack up all those fundamental factors that are generally thought to determine mortgage performance, it signified a red light for the industry," said Michael Youngblood, managing director of real estate research at Banc of America Securities. "We have yet to get any real break in new issuance volume, and there was an inversion of the term-structure of volatility. We only expect one of the factors - volume - to turn into a very solid green light going forward."
For the second quarter, current coupon Fannie Maes had a negative return of 2.41%, while Ginnie Maes had a negative return of 2.82%. The 10-year note was 5.11%, the five-year note, 2.75%, and commercial MBS, 0.93%.
Though mortgages moved basically in line with the five-year Treasury note, most sources said that mortgage fundamental were not yet in place to boost performances going forward.
"Mortgages continue to trade poorly," said an MBS trader. "These days, you get a couple of decently sized sellers in and they move the market around. But the market is not able to absorb activity, one way or the other. When these one or two sellers come in, spreads tighten right up.
"Spreads are just very much affectable' right now," the source said.
It's All About the Fed
Of course, the action of the Fed was one of the main factors that colored the course the market took over the last several months. It still remains to be seen whether the Federal Open Market Committee will adhere to its neutral stance toward the tightening of monetary policy.
On the minds of most market players at the quarter's close is the tone of Fed Chairman Alan Greenspan's upcoming Humphrey Hawkins testimony - as well as any other signals given by the FOMC following its August meeting.
Generally, if the Fed signals that it will stick with its neutral bias, then mortgages are likely to perform well, sources say, and investors will not face extension risk. Additionally, the market will enjoy a significant decline in new issuance volume.
"But if the Fed indicates that the pace of economic activity or employment conditions merit a bias toward tightening," Youngblood said, "then extension risks will reassert themselves and mortgages are likely to underperform other spread product."
Another major issue plaguing the market during the second quarter was a concern over liquidity.
According to sources, it is well known that commercial bank holdings in MBS and real estate mortgage investment conduits declined from the end of 1998.
Plus, Ginnie Mae mutual fund balances slipped significantly since the start of this year. Further, the market has not seen the re-emergence of international investors or arbitrage investors to buoy the market.
In fact, at present, dealers have committed less than $13 billion worth of capital to agency MBS and REMICs, which equals approximately one day's worth of transactions in volume. Comparatively, Youngblood notes, car dealers typically like to keep 90 days worth of inventory around.
"So unless the Fed does exactly the right thing, the likelihood is that mortgages will continue to underperform other spread or quality sectors," Youngblood added.
In addition, going forward, sources say that Y2K concerns will be an important factor affecting liquidity in the market.
"Issuers fear that investors will be sitting on their hands in the fourth quarter, wondering what to do because of Y2K concerns," said an MBS expert. "A lot of corporations are pushing issuance from the fourth quarter back to the third quarter."
Strong Housing Market
Though many sources agree that the market will not generate the type of supply that was present in the first quarter of 1999, there will be some supply emanating from the very robust housing market.
"It is going to be slower supply, which is good for spreads because demand is good," said Linda Lowell, a vice president at Credit Suisse First Boston. "There is not going to be any flood of supply, but undoubtedly liquidity will be better for the next month or so."
Still, housing turnover during the summer months might account for more supply than is expected. But because purchase applications typically start decreasing after June, some Street researchers would not be surprised if they saw a diminished flow of mortgage bankers selling.
"When the applications come down, mortgage bankers sell forward," said Art Frank, head of mortgage research at Nomura Securities. "But we don't think mortgage spreads are likely to come under severe pressure, nor do we see mortgages having a particularly tough time in the next two months."
Generally, activity in July and August is expected to be "somewhat muted," sources say, as summer is traditionally a slow period, mainly because many leading players are on vacation, and junior money managers are hesitant to make major changes in investment strategy. - AT