There were a couple of themes running through last week's market. These were a pick up in bid list activity related to early adopters of FAS 159 and an alignment of various MBS factors that inspired a supportive tone for mortgages.
The Financial Accounting Standards Board voted in February to adopt FAS 159 The Fair Value Option for Financial Assets and Financial Liabilities. The provisions of FAS 159 will take effect at the beginning of a company's first fiscal year that starts after Nov. 15. However, there is a provision for early adoption for entities with a fiscal year that starts before that date. This window for early adoption closes at the end of April.
This early adoption is providing an opportunity for financial institutions to sell underwater mortgage related securities without impacting their income statement. This has led to a pick up in bid list activity last week that is expected to continue through the month. It has also increased concerns about massive selling of discount MBS by banks and insurance companies, says Barclays Capital in a research report.
Analysts believe this concern is overstated for various reasons. One is that those firms that adopt FAS 159 also must adopt FAS 157, Fair Value Measurements, which defines the measurement standards for determining the fair value of assets and liabilities. Meeting FAS 157 in full requires considerable preparation and implementation difficulties may be a deterrent. Under the provisions, an entity must report the reason for selling the underwater assets in its financial statements. Uncertainty in shifting available-for-sale or held-to-maturity assets to trading and then selling might taint assets left in available-for-sale portfolios.
While the bid list selling added supply to the market, it was readily absorbed with active buying from real money, banks, servicers, hedge funds, and even from some overseas investors. Helping provide the supportive tone were higher yield levels from the recent sell-off, lower volatility, stable swap spreads, and the FNMA 5 roll strengthening. Most flows were focused down in coupon spurred by curve flattening, with focus particularly in 5.5%s and 6.0%s. Originator selling, meanwhile, was uneventful holding at between $1 billion and $1.5 billion.
In the first two days of trading in April, mortgages were outperforming Treasuries by nine basis points, according to Lehman Brothers. This is compared to one basis point over for both the ABS and corporate indexes and negative basis points for CMBS. Year-to-date, mortgages are the leader at nine basis points over versus negative eight basis points for ABS, negative 19 basis points for CMBS, and flat for corporates.
Mortgage outlook
This week sees a limited amount of economic data, but there are two key releases: Federal Open Market Committee minutes on Wednesday and PPI on Friday. Other data include Import Prices on Thursday and International Trade and Michigan Sentiment on Friday. There are several Federal Reserve officials making the rounds, including Federal Reserve Governor Frederic Mishkin discussing the economic outlook on Wednesday. In addition, the Treasury auctions 10-year TIPs on Thursday. In mortgages, Tuesday begins 48-hour notification in Class A and on Friday for Class B. As noted, the FNMA 5 roll was heating up and at mid-day Wednesday was trading at 2.5. Traders suggest a squeeze was attempted on the coupon and add that the higher roll was not felt in the specified pool market.
Analysts' sentiment was neutral to positive last week. Those in the neutral camp are concerned with the increasing supply and limited sponsorship. On the supply part of the equation, JPMorgan Securities analysts say that net issuance in 30-years reached an historical high of $35 billion per month recently. They note a significant factor affecting supply has been developments in the ARM market, including ARM-to-fixed refinancing. Analysts at the firm predict that at the current pace, 30-year net supply for this year could easily surpass $300 billion and may even hit $400 billion after accounting for 10/20 IO paper. On the demand side, sponsorship from overseas has been disappointing this year.
Those favorable on mortgages note the recent spread widening and lower dollar prices have improved their value. Citigroup Global Markets analysts also believe that the recent uncertainties related to subprime and equities should wane, encouraging investors off to the sidelines with the combination of the tight rate range (with the Federal Reserve on hold) and the higher interest rate levels.
Like last week, participants generally are expected to be supportive at current levels or on modest back-ups, with market strengthening encouraging bouts of profit taking.
Mortgage applications
As expected, mortgage application activity declined for the week ending March 30, despite mortgage rates holding steady. According to the Mortgage Bankers Association, the Refinance Index was down 4.5% to 2098.3. Still, this is the fifth straight week the index has held above 2000. A year ago, the index was 1575 when mortgage rates were nearly 20 basis points higher. The Purchase Index slipped 2% to 402.9 after holding at 411 for two weeks.
Refinance share as a percent of total applications was 44.5%, down from 45.1% previously. ARM share was also slightly lower at 19.2% versus 20.2%. ARM share is at its lowest since July 2003.
With the increase in mortgage rates last week, along with the religious holidays and tightening in lending standards, application activity is expected to be less in the report for the week ending April 6. The slowing in activity at this time of year is unusual, Mortgage Maxx analysts say. "The long dreaded curtailment of mortgage credit is apparently now starting to be expressed," the analysts warn in a recent report.
Prepayment outlook
March prepayment speeds are expected to rise by 25% or more. The period includes three additional collection days compared with February - 22 versus19 - and seasonals will also begin to pick up at this point. Also contributing to the increase is the higher refinancing activity as a result of the rally in rates. It is expected that some of the application activity that hit in early March (when the Refinance Index hit its highest level since September 2005 at 2312) will have closed in March. Cuspy and less seasoned vintages may be impacted the most as current market levels are relatively attractive versus when the loans were originated.
JPMorgan analysts, however, believe that 2005 and 2006 6.5% vintages may increase less than expectations in part on a tightening in lending standards. In research from Citigroup last week, analysts attribute the prepayment slowdown in part to declining home price appreciation and not so much to stricter underwriting. However, they think higher underwriting standards will eventually have more of an impact. They also believe that home price appreciation is more likely to move lower and not higher because of the increases in new and existing home inventories recently. With the combination of tighter lending standards and weak home price appreciation, Citigroup says it seems likely that high-LTV speeds will slow even more, with an increasing presence into seasoned collateral.
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