Subprime caught the markets' attention again last week, leading to a flight to quality that moved the 10-year Treasury yield back to 5.04% at Tuesday's close. This happened after it hit 5.195% when the June employment report was released on Friday, July 6. That holiday week saw interest rates climb steadily on stronger than expected data, peaking with a 65,000 upward revision in nonfarm payrolls in April and May.
Attention last week, however, was focused squarely on credit as data were on the light side. In particular, Standard & Poor's announced that it placed on watch for potential downgrade $12.1 billion worth of RMBS backed by subprime. Later in the day, Moody's Investors Service announced it had lowered its credit ratings on $5.2 billion in 399 subprime RMBS issued in 2006(See cover story).
There was also more discouraging news on the housing market. D.R. Horton, a homebuilder, reported negative earnings as well as a negative outlook on housing. "Market conditions for new home sales declined in our June quarter as inventory levels of both new and existing homes remained high," said Chairman Donald Horton, "and we expect the housing environment to remain challenging."
The flight to quality rattled the MBS market in the first half of the week and kept volume below normal. June paydown reports were out on Monday and provided some buying support on reinvestment. On Tuesday, flows were mixed, with the opening rally spurring additional selling from real and fast money, further weighted by strong originator supply. After widening to 6+/32nds, money managers and hedge funds reversed their selling and were actively buying all along the coupon stack on the cheapening. As usual, Asian investors remained a limited presence in the midst of increased volatility, subprime market uncertainty and lower yields. Originator selling averaged in the area of $1.5 billion to $2 billion per day. Last Tuesday was also pool notification for Class A (30-year conventional MBS). It was a nonevent, with only Gold 6s and 6.5s showing some specialness.
Mortgage returns remain in negative territory, according to Lehman Brothers. Through July 10, the MBS Index had lost eight basis points so far this month and was down 66 basis points versus Treasurys for the year so far. The ABS Index, down four basis points month-to-date, is the best performing, followed by corporates at negative seven basis points. CMBS is the worst performing at negative 19 basis points so far in July, and also year-to-date, underperforming Treasurys by 82 basis points.
Mortgages remain hostage to subprime woes, and investors will hesitate to be too active until the market settles down. Further mortgage cheapening is anticipated. One piece of subprime news expected this week is Bear Stearns' release of investors' losses on their funds. The firm had anticipated to release this by midmonth.
Last week Barclays Capital analysts offered their views on MBS and recommended an underweight to the basis. The two reasons they cite for the downgrade are that current coupon spread to swaps appear rich on their models and that investors are starting to price in the effect of the weak housing market. Other concerns they have are that the Federal Reserve will need to raise rates and, as investors begin to recognize the increased possibility of a rate hike, real and overseas demand for MBS could be sidelined.
Mortgage applications were up 1% for the week ending July 6 on mixed activity. The numbers were adjusted for the July 4 holiday. In addition, the week saw a slight increase in 30-year fixed mortgage rates to 6.63% from 6.67%.
According to the Mortgage Bankers Association, the Purchase Index rose 3.8% to 453.9, while the Refinance Index fell 3% to 1636.9. The Refinance Index is nearing its lowest level since early Fall 2006 and is affected by the low home-price appreciation, tighter lending standards and lower cash-out refinancings. On the other hand, purchase activity is benefiting from seasonal turnover. A year ago, the Refinance and Purchase indices stood at 1356 and 389, with mortgage rates at 6.79%.
As a percent of total applications, the refinance share was 36.2%, down from 37.8%. ARM share was also lower at 20.4% from 21%. - Sally A. Runyan/IFR MortgageData
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