Subprime continues to hover over MBS, keeping volume below normal. Two weeks ago, it was the rating agencies placing several billion dollars of subprime RMBS on CreditWatch negative. Last week started out with another flight to quality in Treasurys related to declines in ABX indices.
Some of this was reversed on Tuesday as equities rallied to record highs on favorable earnings reports, a tame PPI report, and better-than-expected industrial production. The flight to quality was renewed in the overnight markets on Tuesday and continued into Wednesday morning's session as the market digested the news about the values of the two Bear Stearns subprime hedge funds. The firm reported that the less leveraged fund - the High-Grade Structured Credit Strategies Fund - lost 91% of its value as of the end of June, while the other fund, the High-Grade Structured Credit Strategies Enhanced Leverage Fund, was worthless.
Ahead of the New York open on Wednesday, the 10-year Treasury was up 12/32nds, with the yield down to 5.028%. Meanwhile, 10s had moved off these highs by midmorning on Wednesday as investors took profits from the overnight gains. As the morning progressed, however, rumors were circulating through Wall Street that another U.S. brokerage firm would be booking substantial losses related to subprime. This strengthened the FTQ bid and at midday, the 10-year Treasury was 16 plus ticks higher from Tuesday's close with the yield down to 5.01%.
Federal Reserve Chairman Ben Bernanke appeared before Congress last week with his semiannual report on the State of the Economy. While he reiterated that inflation remains the Federal Reserve's predominant concern, he acknowledged that the slowdown in housing is a challenge for the growth outlook. In particular, the Federal Reserve has lowered its outlook on economic growth to 2.25% from 2.5% in his previous address, while 2008 growth has also been adjusted to 2.5% from 2.75%. The reduction was "largely the result of weaker-than-expected residential construction activity this year," Bernanke said. He also noted the deterioration in the subprime market, but added that on the whole, financial conditions were accommodative for growth.
Housing news remained discouraging last week. On Tuesday, the National Association of Home Builder's Housing Market Index continued to report a dismal housing outlook. Homebuilder sentiment fell four points from June to 24, and was below the consensus call of 27. The number is the lowest since 1991. On Wednesday, the BLS reported higher-than-expected housing starts in June; however, building permits fell more than expected. Specifically, after two monthly declines, the seasonally adjusted annualized rate (SAAR) on housing starts rose by 2.3% to 1.467 million. Building permits dropped 7.5% in June to an SAAR of just 1.406 million, the lowest in exactly 10 years.
MBS volume held to about half the normal daily level, with better selling overall from real and fast money. Flows remained up in coupon with 6.5s particularly favored. Asia also remained disappointing, but hopes are that China will be more active (particularly in GNMAs) following recent comments from Housing and Urban Development Secretary Alphonso Jackson encouraging the country to buy more MBS. Japan was on holiday on Monday, which further limited flows from the overseas contingent. Originator selling averaged $2 billion per day, at the higher end of its recent range. Supply has focused mostly in 6s lately and, to some extent, in 6.5s. Last week was also pool notification on Class C (30-year GNMAs). Most rolls fell out of bed and closed lower.
MBS performance remains disappointing, with Lehman Brothers' MBS Index down 16 basis points month-to-date through July 17 and negative 73 basis points year-to-date. CMBS is the worst-performing sector at negative 30 basis points so far in July and down 92 basis points for the year. Corporates have returned negative 21 basis points in July and are off 18 basis points for the year. ABS is the best-performing sector so far this month at plus one basis point. Year-to-date, however, it is down 26 basis points.
Street analysts were divided last week on their view of mortgages. Lehman analysts recommended overweighting mortgages partly on expectations of an improving supply/demand balance. The supply concerns are a bit overblown, while yield levels, along with strong deposit growth rates, should encourage banks to return to the sector, analysts said. Because volatility remains a risk, they recommend hedging it out.
Credit Suisse said it was maintaining a "constructive" view on the sector. They believe that risk tiering favors agency MBS, along with cheap OAS valuations, positive carry after hedging duration and volatility, and favorable demand technicals. In particular, they like 30-year 6s.
Deutsche Bank, on the other hand, held with its preference for a modest underweight to 30-year fixed-rate MBS. While they also expect some reduction in supply, they are looking for demand to be lackluster. In particular, they believe money managers don't have much room to add MBS, while demand from Asian investors has been sporadic. They also don't anticipate that banks will increase their holdings unless the yield curve steepens further.
Subprime is expected to remain in the markets' headlights in the weeks ahead. The rating agencies are expected to announce further downgrades in subprime RMBS and CDOs. Also, the valuation news from Bear Stearns adds to market fears regarding additional downward revisions on other subprime funds.
Refi Index Gains
After Four Weeks
Mortgage applications rose nearly 1% overall for the week ending July 13. The Refinance Index rose 4.9% to 1717.4, while the Purchase Index slipped 1.6% to 446.5, according to the Mortgage Bankers Association. The gain in refinancing activity comes after four weeks of declines, as well as on a 10 basis point increase in 30-year fixed mortgage rates in that week to 6.73%. A year ago, the Refinance and Purchase indexes were at 1424 and 414, respectively, with mortgage rates at 6.74%.
As a percent of total applications, the refinancing share was 37.7%, up from 36.2% in the previous week. ARM share was also higher at 21%, from 20.4%.
For the remainder of the year, Freddie Mac is forecasting 30-year fixed mortgage rates to hover around their current level and to average 6.5% for 2007 compared with 6.4% last year. Freddie also expects the refinancing share of loan applications to average 35% for the year, down from 43% in 2006. This would be the lowest level since 2000, said Freddie Mac Chief Economist Frank Nothaft. Looking ahead to 2008, he projected that the refinance share would drop to 21%.
July prepayment speeds are expected to slow approximately 10% on average from June on the impact of the substantially higher mortgage rates in June and the decline in refinancing activity. The 30-year fixed mortgage rates averaged 40 basis points higher in June versus May, while the Refinance Index was 12% lower, on average.
The largest percentage declines are expected for 2006 and 2005 6s and 5.5s. Deutsche Bank analysts said that speeds are affected by the decline in cash-out refinancing activity resulting from the limited home equity built up on housing market weakness.
With the ongoing housing slowdown, low home-price appreciation and tighter lending standards, speeds are predicted to hold steady in August (despite a two-day increase in the number of collection days), then decline about 20% in September. Contributing as well to the large expected decline in September is a day count of just 19 days, compared with 23 in August.
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