Even with a flattened yield curve, half of all new mortgage originations are still being driven by refinancings rather than purchases. As a consequence, analysts expect the 15-year share of supply to dip and 30-year production to rise. Further changing the supply landscape, the decline in ARM share of total originations is also expected to continue, driven primarily by home prices moving out of potential buyer's affordability range.
Citing the Lehman Brothers' Aggregate Index return attribution for June showing volatility and convexity as the main performance drivers in 15s versus 30s, RBC Dain Rauscher Vice President Kevin Jackson, noted that net 15-year supply has contracted by $60 billion in the past year, adding that recent prepayment data on the sector has showed comparatively slower 15-year speeds. "Volatility, convexity and strong technicals outweighed the flatter curve," said Jackson.
"My view is that supply will continue to wane a bit," Jackson said, adding that housing demand remains strong but affordability is becoming more and more of an issue, specifically for 15-year product and for ARMs. In fact, Fannie Mae, he pointed out, is currently offering 40-year mortgages to reduce affordability constraints.
"I think 15-year supply will continue to fall," said Jackson, adding that in terms of ARMs, the yield curve will not drive issuance in the sector as much as affordability would. He also noted that banks have decreased their MBS holdings due to tighter margins, attributing current MBS underperformance to the flatter curve. The spread between the two-year and 10-year U.S. Treasury has narrowed 52 basis points since Jan. 31.
Separately, according to Bear Stearns analysts, although the fixed-rate agency MBS market decreased marginally, the first half of the year saw 30-year outstandings increase to $2 trillion from $1.97 trillion. Bear analysts expect net 30-year supply to rise by 3% to 4% in the second half of the year. By contrast, Bear reported that 15-year outstandings and other securities dropped by roughly $30 billion in the first half, adding that the mortgage rate curve has flattened considerably since last October. Bear pointed out that 15-year borrowers usually refinance out of a 30-year loan, but with the spread between 15 and 30-year mortgage rates compressing to less than 40 basis points today "the incentive to refinance from 30-year mortgages to 15-year mortgage has been reduced."
Bear analysts also point out that the spread between 30-year mortgage rates and 5/1 hybrid ARM rates has dipped to just above 50 basis points currently, from 110 basis points in October. Coincidentally, the Mortgage Bankers Association reported that the ARM share of applications dropped to 42% in terms of dollar volume and 27.9% by number of loans, which is the lowest level for the year. "Most of the recent growth in this sector has come from the increased popularity of affordability products like hybrid IOs," analysts wrote, adding that borrowers concerned only with monthly payments would still prefer IO product over any amortizing product, regardless of the flat rate curve. But those who moved into hybrid ARMs for the rate advantage will probably opt out.
Despite the expected drop in ARM issuance, however, Bear still expects net agency ARM supply to rise, partly due to ARMs being underrepresented in the agency universe.
The changes in 30- and 15-year supply composition, along with the narrower yield differential between 30- and 15- year product imply that 30-year technicals could start deteriorating versus 15-years, reported JPMorgan Securities, adding that EITF 03-1 might lead to a rise in regional bank fixed-rate purchase activity. In the past year, bank activity has been mostly in money-center banks participating in 30-year collateral while the regional banks were involved in hybrid ARMs, short CMOs and whole loans. With regional institutions traditionally preferring 15-year product and the sector's current positive valuations and convexity profile, JPMorgan analysts expects stronger demand for 15-year product. "When combined with significant negative supply this scenario bodes very well for the 15-year sector," wrote JPMorgan analysts.
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