When is the Federal Reserve's hand going to be forced on inflation? That was the question that was fueling early week action in the markets last week. On Monday, the tone was the Fed would be increasing rates rather soon. However, an article on Tuesday in The Wall Street Journal said maybe it will not be so soon. The resulting action in Treasurys was a sell-off on Monday with the curve holding flatter, then rallying on Tuesday and Wednesday with the curve steepening.
Mortgage flows were running just below normal through the first half of the week. Monday experienced better selling, particularly from leveraged accounts and servicers - both outright and to move up in coupon. Overseas investor buying picked up on Monday evening and into Tuesday and Wednesday as Treasurys rallied, along with real money, all focused throughout the 30-year stack and in higher coupon 15s.
Money managers were two-way, while servicers continued to reduce positions in 5s and 5.5s. In other mortgage sectors, 15s were mixed versus 30s, GNMA/FNMAs changed only slightly, while specified pools saw steady demand from CMO desks and bank portfolios. Originator selling averaged $1.5 billion per day in the first half of the week and was primarily in 6% coupons.
June has not been kind to mortgages. According to Lehman Brothers, the MBS Index has underperformed Treasurys by 72 basis points so far this month. Other sectors have done much better, with the ABS Index outperforming by four basis points and the U.S. credit and CMBS Indexes lagging by just four and 15 basis points, respectively.
The Senate was expected to vote last week on housing legislation. Senators Chris Dodd (D-CT) and Richard Shelby (R-AL) on the Senate Banking Committee announced last Tuesday that they had completed bipartisan legislation that would provide relief to the housing market and were ready for the full Senate to consider.
In particular, the legislation includes an affordable housing fund that would provide Federal Housing Administration (FHA) loans to allow distressed borrowers to refinance at a significant discount. While this would result in losses to investors and/or lenders, the reasoning is that losses would be greater if the property was foreclosed on.
The program is voluntary, with no lenders, servicers or investors compelled to participate, according to the summary of the legislation. This program will run from Oct. 1, 2008, through Sept. 30, 2011. The bill includes FHA modernization that would increase the FHA's loan limit to 110% from 95% of area median home price with a cap of 150% of GSE limit.
Another important component of the bill is GSE reform, which would create a new regulator for the GSEs and the Federal Home Loan Banks. Included in the GSE reform is an increase in the conforming loan limit in high-cost areas to 150% of the conforming loan limit. This would be $625,000 currently. The Senate is expected to pass the bill. After that, it would have to be reconciled with the House's version before the President could sign off on the legislation. Congress hopes to have a bill before the President on July 4, although the differences between the House and Senate version increase the odds that it will be delayed.
In terms of the mortgage outlook, analysts' tone last week was in the neutral to positive camp. JPMorgan Securities analysts recommended that investors "stay close to home on the basis." Given the current risks of higher interest rates with inflation concerns, they believe the risk/reward favors up in coupon, especially into 6.5s. It is notable that the JPMorgan economists are now predicting a Fed rate hike in September.
Lehman analysts said mortgages are attractive despite some short-term negatives related to convexity hedging. They held with an overweight to mortgages versus swaps with a volatility hedge. In particular, they believe the demand elements are good, especially if there is some stability in the yield curve.
Refis Lowest Since July 2006
As expected, mortgage application activity fell in the week ending June 16 in response to a jump in mortgage rates. The Mortgage Bankers Association (MBA) reported the 30-year fixed contract rate jumped 33 basis points to 6.57% - its highest since July 2007. The one-year ARM rate surged 35 basis points to 7.22%.
In response, the Refinance Index dropped 15% to 1378.6 - the lowest since mid-July 2006. At that time, Freddie Mac reported the 30-year mortgage rate was 6.74% with the Refinance Index at 1378.
The Purchase Index was off 4.3% to 360.2. The MBA noted the Conventional Purchase Index fell 7.2%, while the Government Purchase Index increased 4%.
As a percent of total applications, the refinancing share fell to 37.4% from 39.8%; this is the lowest level since July 2007. ARM share declined to 9.7% from 10.3%.
Speeds are seen slowing 4% to 5% on average in June and by 3% to 4% in July and August due to the sharp slowing in refinancing activity. The MBA's Refinance Index averaged just 2036 in May, down 15.6% from April's average. The slowing in refinancing activity is due primarily to the poor housing market and tight credit standards. Steadily climbing mortgage rates, lower consumer confidence and higher mortgage fees that the GSEs instituted on June 1 are also contributing factors.
Barclays Capital analysts said that the decline in housing has "fundamentally altered turnover and the ability to refinance" and led to tiering in regional prepayment speeds. The states that had the most run-up in home price appreciation over the past five years - Arizona, California, Florida and Nevada - have been the hardest hit by the collapse of the housing market.
Meanwhile, the states that have exposure to the boom in oil or other sources for a strong regional economy, and which also did not experience the explosive HPA that the above states had, are reporting some amount of home price growth, analysts noted. These states are Colorado, Idaho, Louisiana, Montana, Oklahoma, Texas, Utah and Wyoming.
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