The tone in the first half of the week was decidedly more supportive for MBS compared to the previous week. Despite a further sell-off in Treasurys, convexity selling was limited. With spreads at historical wides, many investors became opportunistic buyers.
Monday saw range-bound conditions in most markets, including equities that set mortgages up for their first up-day in five straight trading sessions. Money managers, hedge funds and, to a smaller extent, Asian investors were better buyers and were focused in 5s through 6s, both outright and versus Treasurys and swaps. Flows were down in coupon, although servicers were partially offsetting moving up in coupon.
Mortgages struggled at the start of Tuesday's session as Treasurys were up sharply and equities were indicated to open lower on a larger-than-expected quarterly loss from Wachovia. MBS opened tighter by several ticks, although selling picked up as Treasurys weakened and equities rallied on lower oil prices. Specifically, servicers and hedge funds were selling in the morning to the tune of $4 to $5 billion. However, they became buyers of size in the afternoon as spreads became too attractive to ignore, recovering about 75% of the earlier selling. Money managers were two-way but also more supportive as the day progressed. After widening out to eight ticks versus the curve in the lower stack and five ticks weaker in currents at midday, MBS ended just a plus weaker in 5s and 5.5s and a plus tighter in 6s and 6.5s.
Wednesday continued to see good buying from money managers and servicers, specifically in the lower half of the stack. By midday, 5s and 5.5s were tighter to the curve by 18 ticks (13 ticks to swaps). Contributing to the sharp rally in MBS was news that Congress was set to vote on the housing bill and that President George W. Bush would not veto it.
Later in the afternoon, the House voted to pass the massive housing reform package that extends a lifeline to Fannie Mae and Freddie Mac. Market reports said that lawmakers sped the bill to a vote to make sure that the two agencies have access to capital. The Senate was expected to receive the bill from the House on the same day and vote on it by the end of the week.
In other mortgage activity through midweek, 15s lagged 30s, specified pools were quiet and GNMA/FNMAs were firmer on Monday and Tuesday but weaker on Wednesday. Supply, meanwhile, averaged $1 billion per day.
Month-to-date through July 22, the Lehman Brothers MBS Index was underperforming Treasurys by 108 basis points. Meanwhile, the ABS and CMBS Indexes were down just nine and 29 basis points, respectively, while U.S. credit was lagging by 101 basis points.
Mortgage Outlook
Wall Street research last week highlighted the attractive valuations in MBS. Lehman, for example, noted that spreads are at their widest levels in 10 years, with the exception of a couple days last March.
JPMorgan Securities analysts also made note of the levels and added, "we believe these valuations are unwarranted." They expect the absolute level of returns is likely to attract leveraged investor sponsorship, while the wide spreads to Treasurys should bring in money manager interest, both of which were occurring through midweek. JPMorgan recommended that investors overweight mortgages versus swaps and Treasurys. Their preference was down in coupon, offset with Trust IOs, versus UIC.
Meanwhile, Lehman analysts were neutral concerning the technical aspect, i.e., the short-term duration rebalancing, that still needs to be done and risks of asset sales from other investors. They did recommend, however, 30-year collateral versus 15-year product in the lower coupons "as a way to express a basis overweight with a lower risk profile."
Deutsche Bank Securities analysts anticipated further MBS widening - to new wides in OAS terms as a result of limited demand. They pointed out that the GSEs, which became more active following the Bear Stearns collapse, are no longer able to provide as much support to the market. Convexity selling also adds to the risk of higher rates, as does the ballooning budget deficit risks from the government on all the programs to help the economy, housing and the financial sector.
Finally, UBS analysts moved to an overweight from neutral and recommended an overweight to conventionals versus GNMAs. Their model had MBS five standard deviations cheap versus swaps, and they believe mortgage spreads should tighten when Congress passes the GSE/housing bill. They also looked at the marginal buyers of MBS and believe that total return money managers and foreign central bank purchases for the remainder of the year should be enough to cover the supply. So, "to the extent there is any bank or insurance company demand, that is a net plus," they said
Mortgage Applications Decline
Mortgage application activity decreased in the week ending July 18 as mortgage rates moved higher. The Mortgage Bankers Association said the 30-year fixed contract rate jumped 37 basis points to 6.59%, while one-year ARM rates were unchanged at 7.16%.
In response to that as well as to the overall weak housing and credit conditions, the Refinance Index declined 5.6% to 1392.7, while the Purchase Index fell 6.7% to 335.6. As a percent of total applications, refinancings were little changed at 39.4% versus 39.2% the previous week. ARM share fell to 8.5% from 9.1% previously.
Prepayment speeds are predicted to see further deceleration in July in response to overall market conditions and higher mortgage rates that sent application activity tumbling in June. On average, the Refinance Index averaged 1371, down 33% from May's average. The 30-year fixed mortgage rate averaged 6.32% compared to 6.03% previously.
Currently, speeds are projected to slow about 10% to 15% in July from June, with the largest percentage declines showing in 5.5s and higher. Looking to August, speeds are expected to slow close to 10% from July's estimates. Contributing to this is one less collection day in August.
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