Mortgage flows last week were two-way with participation from both domestic real and fast money. However, overall volume was modest, starting off rather light while the market was waiting for the outcome of the Federal Open Market Committee's meeting on Tuesday. Activity picked up after the FOMC statement was released.
The week saw the 10-year Treasury back up 18 basis points to 4.85% as of Thursday morning. So far, there has been no panic selling in the sector on servicer selling fears, and flows have been orderly. Servicers were only modest sellers; moving up in coupon into 6s and 6.5s as the curve steepened late week. They are expected to become more active after the market breaches above 4.90% and towards 5.0% on the 10-year Treasury.
Overseas investment was mostly absent over the week despite expectations that the higher yield levels would draw these investors in. One reason cited by Deutsche Bank Securities analysts for the lack of participation is that yield differentials between U.S. and non-dollar assets have been narrowing because overseas rates have been climbing faster than domestic rates. Once the spread between the U.S. and other key rates stabilize, Deutsche researchers expect to move to being overweight from neutral. Still, better participation from Asia is expected beginning in April, particularly from Japan as it starts a new year after a brief pause in the latter part of March for year-end.
Analyst sentiment appears mostly neutral at this time with a preference for up-in-coupon. Positives in the market include more favorable valuations, a pick up in demand with the start of a new quarter, corporate crossover buying, ongoing bank and overseas demand, and limited originator selling. Negatives include limited GSE support and weak risk-adjusted carry.
The sector remains directional lagging on sell-offs, and outperforming on strength. Moves up and down the coupon stack reflect shifts in the curve dynamics.
Application activity slightly higher on purchases
Last week the Mortgage Bankers Association reported a slight increase in application activity due to an uptick in purchase activity. The Purchase Index rose nearly 3% to 404 for the week ending March 24, while the Refinance Index was 1% lower to 1558. As a percentage of total application activity, refinancings were up slightly to 38.1% from 37.7%. ARM share slipped to 28.3% from 28.7%.
Meanwhile, as a result of last week's FOMC actions, mortgage rates rose with adjustable rates seeing the larger increases, according to the Freddie Mac primary mortgage market survey released last Thursday. For the week ending March 31, one-year ARM rates jumped 10 basis points to 5.51%, while 5/1 hybrid ARMs rose six basis points to 6.02%. Fixed mortgage rates also increased three basis points to 6.35% for 30-year loans and to 6.00% for 15-year loans.
"The Fed raised rates this week, as we expected, but the market was a little surprised at the Committee's comments, which implied more tightening in the future," Freddie Mac Chief Economist Frank Nothaft said. He added that this has created the impression that inflation might present more of a threat than previously thought. This is an expectation that puts upward pressure on mortgage rates as demonstrated by the rise in rates over the week.
Given the increases, application activity is expected to have slowed last week. The Refinance Index is predicted to decline towards 1500 from 1558 in the MBA's upcoming release.
Strong increases in prepayment speeds are expected for the March report primarily due to four additional collection days for the month. For instance, UBS analysts expect prepayments in March to rise approximately 20% to 25%. April prepayment speeds are anticipated to dip around 10% as day count declines to 19 days, then are expected to pick back up in May as the number of collection days rises to 22.
According to UBS researchers, most of the month-to-month variation in speeds will come in discounts, considering that day count is the overriding factor in prepayment changes through April. They noted again that there are 19 days in February, 23 in March, and 19 in April.
More on FAS 156
As discussed in last week's ASR, a recent amendment to FAS 140 - FAS 156 - is expected to ease hedging of mortgage servicing rights, allowing volatility to decline even further.
Credit Suisse analysts last week commented on the change. They expect wide market acceptance of FAS 156 as the amendment eliminates the need for servicers to comply with the more complicated FAS 133 ruling, and it reduces the sensitivity of servicers to rising interest rates. "While servicers retain the option to use any of the pre-existing treatments, we expect broad-based adoption of FAS 156," analysts wrote.
The researchers also anticipate that the impact of FAS 156 would be felt almost immediately as it will be a net positive for servicer earnings, citing Countrywide and Washington Mutual - current users of FAS 133 - as good examples.
Researchers explained that FAS 156 eliminates the risk of market-disruptive hedging activities sometimes initiated by servicers as well as the potential for related earnings volatility on servicing portfolios. The root cause of this, they added, was a misalignment between accounting and economic treatment. This arises from situations such as when servicers who use the available-for-sale classification for hedges that fall under the lower-of-cost-or-market accounting method. Under this scenario, rates rallying have led to potential mark-to-market gains but are often frowned upon by management and accountants.
The new amendment could also limit the comparability of hedging activities across servicers since it allows for each institution to define a "class" of servicing rights on which to apply the fair value method.
FAS 156 is effective for fiscal years beginning after September 15, 2006, but companies are allowed to adopt the new standard at the start of their respective fiscal years. Analysts believe that most servicers have started using FAS 156 in the first quarter of this year. Servicers who switch to the new accounting are allowed a one-time opportunity to reclassify available-for-sale securities to trading securities without tainting their portfolio in regards to their investment classification under FAS 115.
Credit Suisse reports the top 10 servicers hold a 55.3% market share in mortgage servicing rights. Countrywide, Wells Fargo and Washington Mutual represent 29% of that amount.
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