With mortgage-backed supply expected to rise significantly this month, analysts said that it would start to weigh more heavily on the market given that economic recovery is on the horizon.
Researchers from Deutsche Bank Securities stated that gross supply of fixed-rate agency mortgages is expected to reach a whopping $171 billion this month. This figure goes over last month's showing of $132 billion, which is already historically high.
Analysts added that $133 billion alone of the $171 billion could be attributed to paydowns from the prior month. They also expect 15-year mortgages to continue to comprise a disproportionate portion of the supply at 36%. This is in contrast to only 21% of the MBS index, but is actually in line with the last month's share of 38%.
"Supply is starting to weigh slightly on the market, but buyers remain active," wrote Paul Check, analyst at Deutsche. "We expect supply to weigh on the market more as there is a recovery in the economy in general and in corporate bonds in particular."
Check said that this is a result of the following factors: 1) money managers will start changing their recommendations from overweight in mortgages and underweight in corporates; 2) as the economy recovers, Fannie Mae's duration gap will close and probably even become positive; 3) banks will likely shift from mortgages to loans. These three factors, said researchers, will lessen the demand for new mortgages and thus result in supply actually pushing prices lower.
Analysts stated that some evidence of the first factor is already in play as corporate and high yield bonds were performing well in recent trading sessions, while mortgage supply seemed to weigh more heavily on the market. The second factor - Fannie's duration change - will probably occur more smoothly than the first. Researchers said that this is because the effect on the Fannie's duration gap and subsequent decrease in the demand for long duration mortgage assets will be proportional to any increase in interest rates. The third factor is probably going to take more time to happen as the loan credit requirements of banks will have to dip before they go into loans over mortgages.
Other analysts are starting to get concerned about the fact that the supply/demand situation has been extremely favorable recently, but may become less favorable in the near future.
"We benefited over the last three months from the fact that the 30-year passthrough market has shrunken, with issuance having been below paydowns," said Art Frank, head of mortgage research at Nomura Securities International, last Tuesday. "To a considerable degree, that's because there has been a lot of refinancing from seasoned 30-year product into 15-year paper. This has given a boost to the thirty-year current coupon market. Now that the refi wave is past its peak, the favorable supply/demand dynamic will probably reverse early next year. So we've had a very favorable situation for 30-year passthroughs that has been helpful to the market. This factor might not be there by the end of first quarter 2003."
Breaking records
JPMorgan analysts said that 2002 would be the biggest issuance year ever - with a staggering estimated $2.5 trillion in mortgage originations. This follows 2001's showing of $2.2 trillion in originations. For perspective, researchers wrote that the mortgage market is worth about $5.8 trillion. This would mean that the mortgage market has turned over by roughly 40% in 2002 and 2001. They said that this is an important factor to keep in mind in light of the maximum capacity of the mortgage banking industry.
"Capacity constraints provide a duration floor for the mortgage market," wrote David Montano, head of mortgage research at JPMorgan
For instance, Montano said that in early October, most Street models had the mortgage index duration at well under one year. This is one reason why Fannie Mae had a 14-month duration gap in September. But, a 0.7-year duration for the whole MBS market would mean a prepayment rate of above 75% CPR; this would, in turn, require about $4.5 trillion in annual origination. This level, he stated, is well above the capacity of the mortgage banking industry. The top origination month on record was October, at slightly above $240 billion in total originations (or a $2.9 trillion dollar pace).
"Thus, even with almost the entire mortgage market refinanceable and the MBA refinancing index over 6000, production seems only to imply market speeds of around 50% CPR," stated Montano. "If that is the maximum capacity, then the duration floor of the mortgage market is around 1.3 years."
He added that there have been a few mortgage originators that have considerably boosted capacity in 2002, but most of them have just grown modestly because of the costs associated with bulking up' to cope with the refinancing onslaught.
Analysts said that to increase staff during a refinancing wave is a very risky business strategy. Once refinancings actually slow down, it would be very expensive for mortgage bankers to scale down their businesses.
"We believe the most successful mortgage banks will be those that manage to most efficiently scale between refinancing and purchase environments," wrote Montano.
