MBS continue to see mostly below-normal volume as a result of the ongoing deterioration in housing, subprime and funding. Many market players also remained out on late summer vacations, which contributed to the limited activity.
Flows last week were mixed, though surprisingly, some widespread buying interest showed up at midweek - apparently related to news that the European Central Bank (ECB) could add more liquidity to its markets later in the week if conditions remain poor. Interest was along the coupon stack, though the preference was mostly up in coupon.
Also hurting MBS participation was the weakness in dollar rolls.
"It will be tough for MBS to do well if pass-through financing remains a problem," said Alec Crawford, a managing director at RBS Greenwich Capital. However, there was some improvement midweek in rolls following the ECB news.
With all the uncertainty, overseas activity in MBS remained mostly quiet. Meanwhile, GNMAs were pressured by supply worries associated with the agency's announcement that it would eliminate the loan size limit for pooling mortgage loans guaranteed by the U.S. Department of Veteran Affairs effective Sept. 1. Also affecting supply worries was U.S. President George Bush's FHA Secure initiative, which would help creditworthy borrowers who are having problems making payments on time following loan resets by offering an option to refinance their existing mortgages. Investors were also concerned about how the inclusion of these refinanced loans would affect the character of the pools. In light of the market's concerns about these changes, Ginnie Mae will be meeting with the Bond Market Association in an effort to clarify the inclusion of pools into TBA and what their impact will be.
Finally, originator selling picked up and was averaging about $1.5 billion per day, compared with $1 billion in the previous week. Supply is primarily in 6% coupons.
It has been a tough year for the mortgage market. Year to date, MBS are lagging Treasurys by 171 basis points, according to Lehman Brothers. In August, the MBS Index underperformed by 26 basis points, and in the first day of trading for September, it was down three basis points. On the bright side, however, year-to-date mortgages are leading ABS (negative 255 basis points), CMBS (negative 274 basis points), and corporates (negative 267 basis points).
Housing News Remains Discouraging
Data on the housing market continued to be discouraging. On Wednesday, the National Association of Realtors (NAR) reported that its Pending Home Sales Index fell 12.2% in July, to 89.9, its lowest level since September 2001 and substantially below expectations. The NAR directly attributes the July decline to tightening mortgage lending standards, a situation that worsened in August. NAR members said that, "some sales contracts aren't closing because mortgage commitments have been falling through at the last moment." The NAR believes the problems are temporary and that they primarily affect jumbo loans and subprime borrowers. Further declines are anticipated in the August report, because it was then that the subprime and credit fears brought the markets to a standstill and forced the Federal Reserve to cut the discount rate and release a statement.
FHLMC Releases Home Price Index
Freddie Mac released its quarterly Conventional Mortgage Home Price Index for the second quarter a short while ago. In the second quarter, home values rose just 0.4% on an annualized basis, Freddie Mac said, down from a revised first quarter growth of 2%. Freddie noted this was the slowest quarter in 12 years.
It also reported that over the 12 months ended June, HPA was 3.3% on average, compared with 10.2% over the same period a year earlier. At the end of August, the Office of Federal Housing Enterprise Oversight (OFHEO) reported similar results, with second-quarter annualized growth at 0.33% and growth from second quarter of last year at 3.2%.
Freddie reported that five of its nine regions recorded negative annualized quarterly growth: New England (-2.2%), Middle Atlantic (-0.4%), South Atlantic (-0.2%), East North Central (-0.5%) and Pacific (-1%). West South Central (which includes the states of Arkansas, Louisiana, Oklahoma and Texas) recorded the strongest growth rate, at 5.1%, followed by East South Central (Alabama, Kentucky, Mississippi and Tennessee) at 4.9%.
Amy Crews Cutts, Freddie Mac's deputy chief economist, attributed the losses in the East North Central states to manufacturing employment losses. Losses in the other regions, whose economies were otherwise healthy, were due to the housing slump. There was some encouraging news, said Cutts. The declines so far are not as deep as during the defense industry slump in the early 1990s or the energy market crash of the 1980s.
For this week, the events calendar is limited, with some Federal Reserve officials speaking at the start of the week before they enter their quiet period ahead of the Federal Open Market Committee's (FOMC) meeting on Sept. 18. On Monday, FRB Atlanta's Dennis Lockhart, San Francisco's Janet Yellen and Federal Reserve Governor Frederic Mishkin are scheduled to speak at various functions. Also scheduled on Thursday is a Treasury note auction - a reopening of the 10-year note.
In MBS, in addition to prepayment information for August coming out on Monday, Tuesday is 48-hour notification for Class A and on Friday for Class B. Most rolls are negative. Traditionally, these events are supportive for the MBS sector, but this does not seem likely considering the broader issues consuming the markets: subprime credit, looming ARM resets, a potential increase in Federal Housing Authority issuance, high financing costs and the lack of a CMO deal bid, to name a few of the negatives. With this and the looming FOMC meeting, MBS flows are likely to remain limited with better selling on any opportunities.
Barclays Capital analysts last week said they remained negative on the mortgage basis as they expect spreads to remain under pressure - even if the Federal Reserve cuts rates. Analysts said that an easing in monetary policy of 25 to 50 basis points is not likely to provide a quick solution for spread products. It would take a much larger cut to stimulate investors, but inflation and growth outlooks make this difficult, they said. Because of its current monetary limitations, however, the Federal Reserve will continue to pursue other options, such as accepting illiquid assets at its discount window and relaxing some regulations. Barclays also pointed out in its report that easing in 1998 did not help MBS spreads.
Other factors likely to keep pressure on spreads are additional CDO downgrades, dealer earnings news, the illiquid secondary markets, short-term funding issues and ballooning bank balance sheets.
Analysts say that CDO rating downgrades have yet to begin in earnest, and when they do, they will likely trigger further unwinds - even from real money investors without leverage. There are already warnings about substantial declines in earnings.
Many Wall Street firms, such as Lehman Brothers, Bear Stearns and Merrill Lynch, are scheduled to release their reports before the Federal Reserve's September meeting.
With the ABCP market drying up, entities are having to turn to banks to get short-term funding by tapping lines of credit, bridge loans and extra mortgage collateral from leveraged investors facing problems. This is ballooning bank balance sheets, analysts said. They added that this pushes banks to hold onto their liquidity and extend less credit to the real economy.
Mortgage Application Activity Rises
Mortgage application activity increased slightly in response to recent declines in mortgage rates. For the week ended Aug. 31, Freddie Mac reported that the 30-year fixed mortgage rate fell to 6.45%, its lowest level since early June.
According to the Mortgage Bankers Association, the Purchase Index was virtually unchanged at 425.8 for the last week of August, compared with 424 in the previous week. The Refinance Index gained 2.3%, to 1770.2, from 1729.6. For the month of August, the Refinance Index averaged 1823, up 7.7% from July's average. The 30-year fixed mortgage rates were 13 basis points lower on average at 6.57%.
As a percent of total applications, refinancing share was 41.4%, up from 40.4% in the previous period. ARM share fell to 12.6% from 15% and is at its lowest since May 2003 in response to the jump in ARM rates. It reached a high of nearly 37% in March 2005.
August Prepay Reports Looming
On Sept. 7, the GSEs release data for August prepayments, followed on Monday by Ginnie Mae. Paydowns are estimated in the mid-$30 billion area.
Speeds are projected to increase less than 5% in August for FNMA and GNMA 30-year MBS. There is a two-day increase in the day count from July. However, this is partially offset by reduced refinancing activity in July on slightly higher mortgage rates. For example, in July, the 30-year fixed mortgage rate averaged 6.7% versus 6.66% in June, and the Refinance Index was 1693, down nearly 4% from June's average.
Speeds are currently expected to decline around 15% in September on a combination of a decline in day count to 19 from 23 and slowing seasonals with the start of fall. An increase in the number of collection days to 22 in October will contribute to an expected 10% to 15% increase in prepayments.
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