Through midweek last week, mortgages experienced modest two-way flows and a less supportive tone versus the first week of November.
Heavy and widespread buying - pushed by the improvement in Libor and dollar rolls - had Barclays Capital's MBS Index outperforming Treasurys by 89 basis points through Nov. 7. This, in turn, has made investors more cautious about protecting their gains in the current financial environment.
Volume was substantially below normal on Monday, as it was a short trading session ahead of a full close on Tuesday for Veterans Day. In addition, many participants were out for the Securities Industry and Financial Market Association's summit on the Troubled Assets Relief Program (TARP). There was notable overseas and domestic bank interest, along with money manager buying, but this was offset by originator and other investor selling.
Spreads closed several ticks wider, with lower coupons lagging as investors moved up in coupon following the previous week's outperformance in lower coupons. This move was also fueled by prepayment data that showed a very limited response in October despite attractive mortgage rate levels.
Mortgages were going back and forth on Wednesday, though by midday, spreads were several ticks tighter with down in coupon outperforming as Treasurys rallied and stocks sold off on increased economic concerns. Spreads opened weaker on follow-through from Monday, but the cheapening attracted Asia and real money, which pulled spreads slightly tighter.
Spreads widened again when selling picked up on remarks Treasury Secretary Henry Paulson made during his update on the state of the financial system, the economy, and the government's strategy for continued implementation of the financial rescue package (see cover story). But this was short lived, as investors took advantage of the negative response to add on weakness.
"Over these past weeks we have continued to examine the relative benefits of purchasing illiquid mortgage-related assets," Paulson said. "Our assessment at this time is that this is not the most effective way to use TARP funds, but we will continue to examine whether targeted forms of asset purchase can play a useful role, relative to other potential uses of TARP resources, in helping to strengthen our financial system and support lending. But other strategies I will outline will help to alleviate the pressure of illiquid assets." For many market participants, there was a sense of "bait and switch" on what TARP was originally intended to do.
However, the U.S. Treasury is believed to be buying MBS outside of TARP. A report that would provide more information on this was expected to be issued after press time. JPMorgan Securities analysts estimated that the Treasury purchased about $15 billion of agency MBS, up from $5 billion in September. If purchases did equal $15 billion, it would mean more than half of the $27 billion in net MBS issuance for October.
Street analysts were neutral on mortgages last week. Barclays Capital analysts, for example, maintained their neutral outlook on the agency mortgage basis, as they think that the positives of improved funding and belief that banks appear to be using TARP money to buy mortgages are offset by the negatives of GSE earnings news and the prospect of increased origination on lower mortgage rates.
Bank of America analysts returned to a neutral stance on Election Day, and remained there last week. Their concerns included uncertainty regarding overseas demand, as well as the sense that current dollar price levels are too high to attract active buying from banks. At the same time, they noted that MBS are attractively priced versus Treasurys, while they expect net issuance will likely continue to decline over the next four months, given the negative seasonal factors in the housing market. Furthermore, if rates continue to rally, the analysts expect that servicer-convexity related buying could pull spreads tighter versus Treasurys.
After a strong start to November, JPMorgan moved to tactically neutral from overweight on the MBS/Treasury basis. Longer-term, however, they see several favorable factors, such as lower supply, and increased bank and Treasury sponsorship.
In terms of banks, analysts believe they will be pressured to invest the equity invested in them by the government. "We estimate $50 billion could be used as capital for the purchase of large amounts of MBS down the road," analysts said.
November prepayments are predicted to decline about 20% on average from October, with paydowns estimated at $34 billion. The slowing appears to be fairly uniform across coupons and vintages. Contributing to the decline are four less collection days and a decline in refinancing activity. The Mortgage Bankers Association's Refinance Index averaged 24% lower in October versus September; this in response to a 16 basis points increase on average to 6.20% on 30-year fixed mortgage rates.
JPMorgan analysts, however, are anticipating about a 10% (versus 24%) decline, as they believe that some of the closings that were expected for October were delayed into November. October speeds increased substantially less than expected. A longer appraisal process was one reason suggested for the lag.
December speeds are currently projected to increase about 15%, because the number of collection days increases to 21 from 18.
GSE Buyouts Looming?
With the placement of the GSEs into conservatorship, there has been anticipation that they will begin again to buyout delinquent loans. The GSEs started delaying this practice beginning late last year, based on their growing need to preserve capital.
Adding support to this expectation were comments from Federal Housing Finance Agency Director James Lockhart in September. Lockhart said that the regulator would be working with the GSEs to modify some of their business practices. GSE practices to be addressed include the "lengthy delay" in removing delinquent loans from pools. Barclays Capital analysts believe the GSEs will become more aggressive on this issue, which could cause speeds to spike considerably if they decide to remove all 120+-day delinquent loans within a short time frame.
As an example, if all the accumulated 120+-day delinquencies are bought out over a three-month period, speeds on 2007 6.5s could spike up 18 CPR, while 5.5s could see a 4 to 5 CPR increase, Barclay's analyst said.
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