Volume was below 50% the normal amount in the last week of 2007. Many market participants were out for extended vacations and Wall Street desks were thinly staffed. The flows taking place were mixed and reactive to moves in Treasury rates. The days after Christmas saw some buying interest from overseas investors and money managers that helped hold spreads tighter with a modest amount of month-end buying thrown into the mix. Originator selling averaged about $1.5 billion per day.
Mortgages closed 2007 significantly lagging Treasurys as a result of the housing crisis, although performing substantially better than competing sectors. Lehman Brothers said that excess return versus Treasurys on the MBS Index was negative 187 basis points, negative 445 basis points for CMBS, negative 456 basis points for U.S. Credit and negative 629 basis points in ABS.
With the improvement in mortgage rates and stronger refinancing activity in November, December prepayment speeds are projected to increase around 2% in aggregate on 4.5s through 6.5s. In November, the 30-year fixed mortgage rate averaged 6.20% as reported by Freddie Mac. This is down 15 basis points from October's average. At the same time, the Refinance Index averaged 2,343 in November, up nearly 12% from the previous month. Prior expectations had speeds slowing about 7% to 8% based on a lower day count and slower seasonals.
Concern Over Technicals
The 2008 outlook for MBS technicals remains a concern, particularly for the first part of the year. Preliminary estimates of net fixed-rate agency issuance this year are around $540 billion on average with roughly 90% expected in 30-years. Meanwhile, the prospects for MBS sponsorship are not encouraging, particularly from banks, the GSEs and crossover investors.
Bank demand is expected to be flat to negative this year as a result of the ongoing credit and subprime crises. This should increase the pressure on capital ratios and balance sheets, analysts said. However, toward the end of the year, improvement in capital should lead to more MBS demand. Additionally, if the Federal Reserve begins to lower rates aggressively, demand from this source would likely pick up.
The GSEs were expected to be better supporters. However, recent disclosures of losses from these agencies, as well as the need to increase their capital, have decreased expectations for MBS demand from them. Increased agency MBS selling is expected in the near term if there are more losses. There is also the potential for credit loss provisions to rise, which might cause the agencies to be more cautious about adding to their portfolios. The GSEs might be more active buyers if restrictions on their portfolio caps and surplus capital are lifted, which will be possibly sometime later this year.
MBS buying by overseas investors should continue, although at a slower pace than in recent years. Possibly limiting overseas participation are higher dollar prices, currency risk and increased volatility. Continuation of the credit crisis should also hinder liquidity flow into the sector.
Bear Stearns analysts said that agency MBS should still have a healthy share of foreign investment in U.S. debt based on its attractive spread to Treasurys and agencies, safety and liquidity.
Other investor classes are mixed. Crossover buyers now have better alternatives in other sectors, such as long IG credit. Hedge funds might become less active as a result of banks' balance sheet constraints. The outlook for money managers is mixed. Barclays Capital analysts, for example, said that money managers are, to some extent, already overweight in MBS. This would make them less active buyers unless the Fed further lowers interest rates. On the other hand, RBS Greenwich Capital expects these investors to be as active in 2008 as they were in 2007. Total rate of return investors should be active this year partly because of the shrinking non-agency sector.
Generally, however, the thought is that mortgage-backeds need another marginal buyer to step in to absorb the strong predicted supply.
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