Summer vacations and ongoing worrisome conditions kept MBS volume below normal through the first half of the week with better selling overall following the sector's strong rally on the previous Friday.
There were several disconcerting reports out that made a recovery elusive to this credit and housing crisis, and thus kept MBS buyers on the sidelines. A number of reports influenced last week's mortgage market activity including UBS stating a larger-than-expected 2Q08 loss of $328.9 million, JPMorgan announcing that it had incurred losses of $1.5 billion since July and several analysts issuing various downgrades to Goldman Sachs, among other things.
Monday's selling came largely from servicers - reportedly totaling in the $2 billion area, but hedge funds, insurance companies and foreign banks also added their share as Treasurys sold off sharply.
Flows were mixed on Tuesday as the Treasurys garnered a flight-to-quality rally with some light opportunistic buying from money managers, hedge funds and banks. Still, sellers outnumbered buyers 2:1.
Focus of activity in the beginning of the week was in 5.5s and 6s. Wednesday's tone was more supportive with better buying reported from money managers and hedge funds following a slightly weaker-than- expected retail sales report and a more range-bound market. Sellers, however, were quick to emerge on the tightening. Mortgage spreads were unchanged to slightly tighter at midday compared to five ticks wider on average versus the curve on Monday and Tuesday.
Asian investors remained sidelined, while originator selling averaged between $1 billion and $1.5 billion per day. While the supply was light, it added weight to a market that has a dearth of buyers at the moment. In other mortgage-related activity, 15/30s were about in line, specified pools were quiet and GNMA/FNMAs were mixed to unchanged.
Month-to-date through Aug. 12, Lehman Brothers' MBS Index was underperforming Treasurys by 81 basis points. This is compared to negative 59 basis points for ABS, negative 128 basis points for CMBS and one basis point for U.S. credit.
Mortgage Outlook
In Street research last week, JPMorgan Securities analysts continued to recommend a mortgage overweight. One reason was improved technicals, as agency supply is expected to be lower in the second half of this year. They believe there is significant risk to a short position in the event the government intervenes - as this could cause spreads to tighten significantly, they said.
UBS analysts also held with their overweight, as valuations look cheap and they expect that volatility is apt to remain contained. They also noted the expected lower supply in the second half of this year versus the first.
Meanwhile, Barclays Capital analysts turned neutral on the MBS basis. They said that while valuations look cheap, they are leaning toward the cautious side with investor confidence in the GSEs shaken. They believe that if the Treasury does make a capital infusion, the basis should benefit.
Until this happens, analysts believe "investors could incur significant mark-to-market volatility trying to capture MBS at fundamentally cheap spread levels." As a result, they prefer to be neutral on the basis "but would look to go long if news of a capital infusion were made public."
While valuations are attractive on a historical basis, the very near-term outlook supports the ongoing "day-trading" mode of opportunistic buying and selling.
In addition, activity tends to slow down in the latter half of August as participants take their summer vacations, and this will further inhibit flows. Deleveraging is expected to continue with bank balance sheets stressed, which will keep credit standards tight.
Asian investors also appear to be on hold, but that could be due in part to seasonal patterns. JPMorgan analysts observe that while actual central bank custody holdings of agency securities have fallen, it is "completely consistent with seasonal patterns observed from 2002 - 2007."
They said that this seasonal analysis suggests that it could be several more months before foreign purchases pick back up. Also disconcerting for the market and investors is that GSE support is out of the equation as these agencies deal with preserving capital in the face of large losses.
Mortgage Application Activity Slips
Mortgage application activity was down slightly for the week ending Aug. 8 as refinancing activity slipped and purchase activity held steady. The Mortgage Bankers Association reported that the Refinance Index erased most of the previous week's gains, slipping 4.2% to 1074.6. Refinancing activity remains at its lowest since the end of 2000. Meanwhile, the Purchase Index remained unchanged at 315.2.
Higher mortgage rates contributed to the slowing with the 30-year fixed contract rate jumping 16 basis points to 6.57%. The average contract interest rate for one-year ARMs was down two basis points to 7.15%.
As a percent of total applications, refinancing share was 35.2% compared to 35.9% in the previous report. ARM share was higher at 7.3% versus 6.9%.
The intermediate outlook for speeds is for ongoing slowing. The latest salvo to limit refinancings was the raising of G-fees by both Fannie Mae and Freddie Mac. Beginning Oct. 1 for Fannie and Nov. 7 for Freddie, the GSEs are increasing their up-front guarantee fee and adverse delivery fee to 50 basis points from 25 basis points. In addition, both will implement new FICO/LTV matrixes.
"At the margin, the latest increase in the G-fees would decrease refinancing incentives for borrowers and slow prepayment speeds further," Barclays Capital analysts said.
With the combination of further home price erosion, higher mortgage rates, low consumer confidence and higher unemployment rates, on top of the higher G-fees, Barclays projects speeds on 5s through 5.5s to slow to 5-5.5 CPR, 6s to 7 CPR and 6.5s to about 10 CPR over the next few months. JPMorgan also believes that unless there is some major government refinancing incentive, "prepayments are on schedule to reach new record lows by the end of the year."
Looking to August, speeds currently are expected to slow 10% to 12% from July's estimates. The largest percentage declines are in 6% coupons and higher. Contributing to this is one less collection day in August, along with higher mortgage rates and lower refinancing activity.
For the month of July, the Refinance Index averaged 1289, down 6% from June's average of 1371, while the 30-year fixed mortgage rate, as reported by Freddie Mac, averaged 6.43% compared with 6.32%.
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