Mortgages were off to a very poor start for December. This is despite the news that the Federal Reserve would be purchasing $500 billion of MBS over the next several quarters, announced just before the Thanksgiving holiday.
A strong flight-to-quality was in place as negative economic data and outlooks were released. The trade was further strengthened last Monday following comments made by both Fed Chairman Ben Bernanke and by U.S. Treasury Secretary Henry Paulson. Bernanke's remarks caused the 10-year Treasury bond, which was already up a point on the day, to increase over another point. This happened after the Fed chairman mentioned the possibility of buying "longer-term Treasury or agency securities on the open market in substantial quantities" to help influence mortgage rates.
He also said he expected economic conditions to remain weak for a while. "In particular, household spending likely will continue to be depressed by the declines to date in household wealth, cumulating job losses, weak consumer confidence and a lack of credit availability," Bernanke said.
Paulson indicated that the Treasury is working on additional programs to help the financial and housing markets. "There is no single action the Federal government can take to end the financial market turmoil and the economic downturn," he said. "In these extraordinary times, we must instead focus on developing the most effective combination of our tools to further stabilize our financial system and speed the process of recovery." Paulson also warned that further slowing of the economy threatens to prolong the housing correction.
For November, Barclays Capital MBS Index posted a negative return of 68 basis points versus the curve and negative 169 basis points versus swaps. The mortgage sector was better versus ABS (negative 316 basis points), CMBS (negative 2259 basis points) and corporates (negative 176 basis points), but lagged agencies, which underperformed by just nine basis points. Year-to-date, mortgages are down 248 basis points compared with negative 276 basis points for agencies, negative 2065 basis points for ABS, negative 4696 basis points for CMBS and negative 2163 for corporates.
Mortgage Application Activity Surges
The sharp drop in mortgage rates following the Fed's announcement that it would purchase agency debt and MBS led to a surge in applications. The Mortgage Bankers Association (MBA) reported that the Refinance Index soared with a record percentage gain of 203.3% to 3802.8, and the Purchase Index jumped 38% to 361.1. The Refinance Index is at its highest since the week ending March 21, when it rose 82% to 4255 when mortgage rates dropped to 5.87% from 6.13%.
The MBA's report said the average contract rate on 30-year fixed-rate mortgages dropped 52 bps to 5.47%, 15-year rates were down 65 basis points to 5.13%, and one-year ARM rates fell to 6.61% from 6.87%.
As a percentage of total applications, refinancing share was 69.1% versus 49.3% in the previous report. This is the highest refinance share has been since mid-February. ARM share slipped to 1.4% from 3%.
For the month of November, the Refinance Index averaged 1897, up 31% from October's average, with mortgage rates averaging 6.09% compared to 6.20% previously. With the improved rates, prepayments could be higher than is currently projected for the December report (released in January). Currently, speeds are predicted to increase between 10% and 15% as the number of collection days increases to 21 days from 18.
In their 2009 MBS outlook, JPMorgan Securities analysts recommended an overweight to MBS versus Treasurys heading into the new year. They based their recommendation in part on their supply/demand outlook in the MBS sector, as well as surging Treasury issuance and the prospect for narrower swap spreads in the front end. In a Credit Suisse report, analysts estimated that the combined Treasury and Federal Reserve purchases should exceed 2009 net supply by 25% to 40%. Barclays Capital recommended investors go long on the mortgage basis, as they say the Fed's purchases could be larger than their estimate for net supply in 2009 of $420 billion.
Is a Refi Wave Looming?
JPMorgan analysts believe that prepayment speeds have reached a bottom, and they anticipate that next year they will turn higher and converge with GNMAs. Government actions that reduce the cost of refinancing such as removing the excess g-fees and streamlining the process, however, could trigger a "mini-spike" and increase speeds 10 to 15 CPR, they said.
Merrill Lynch analysts also consider the possibility of some level of a refinance wave given current coupon yields and the primary mortgage rates that could result. One scenario is based on the current tight lending environment with current coupon yields of about 4.75%. Under these assumptions, they project 5% could reach 15% CPR, 5.5s 24% CPR, 6s 28% CPR and 6.5s 27% CPR. They noted that these speed levels, particularly for premium coupons, are lower than what was observed in 2003.
Merrill's second scenario assumes a loosening in the underwriting standards in terms of LTV and credit score. In this instance, they believe 5.5s could hit 35% CPR, 6s 41% CPR and 6.5s 38% CPR - levels that are more in line with 2004.
Current mortgage rate levels have increased the universe of borrowers with an incentive to refinance. According to Credit Suisse analysts, at a 5.35% mortgage rate, 72% of 30-year MBS has at least a 50 basis point incentive. At a 5% mortgage rate - which they expect in 1Q09 - this would jump to 87% exposure. Analysts noted, however, that the "effective" refinancing exposure is reduced by about 30% at a 5.35% rate and 10% at a 5% rate as a result of the additional g-fees, as well as underwater and doc-impaired borrowers. Given this, analysts believe that speeds observed in February of this year likely are the ceiling on prepayments unless mortgage rates dip below 5%. Even at that level, they don't expect that speeds will reach 2003 levels due to the condition of the housing market.
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