Subprime continued to weigh on the MBS market last week. Treasurys strengthened on "flight to quality" related to subprime as well as on weak housing news.
On the subprime front, Bear Stearns stock was hit early in the week on fears that the firm's $3.2 billion bailout of one of its subprime hedge funds might not be enough. Rumors were circulating on Tuesday regarding Countrywide Financial's subprime exposure, which also caused its stock to decline. Finally, ABS remittance reports showed that delinquencies on outstanding pools of subprime mortgages continued to rise. The market is starting to anticipate again that the Federal Reserve could cut rates at some point with the weakness in the housing market.
In the June 18 week, the 10-year Treasury yield peaked at 5.165% and by midday on Wednesday, June 27, it was down to 5.043%. A weak durable goods report contributed to a strong rally on Wednesday morning, with the 10-year Treasury up 17+ ticks at one point following the release. Between the Treasury strength and subprime jitters, which also pushed volatility higher, MBS volume was running below normal last week. Flows were two-way and moving up in coupon, though sellers retained the edge. Overseas held mostly to the sidelines, and originator selling was in the $1.5 billion to $2 billion area and focused primarily in 6% coupons.
Month-to-date through June 26, the Lehman Brothers MBS Index is down 47 basis points, with year-to-date at negative 51 basis points. The sector is the worst-performing sector for the month and year-to-date is just two basis points better than CMBS. Month-to-date, ABS has returned negative nine basis points, CMBS negative 24 basis points, and corporates negative 33 basis points.
Mortgage Outlook
In research last week, analysts appeared to have a mixed tone. For example, Deutsche Bank Securities analysts remained slightly negative on 30-year MBS as they expect supply to outstrip demand (despite higher mortgage rates). They added that mortgages are also currently market directional, given that they are trading with longer durations and so are likely to widen in selloffs and tighten in rallies.
On the other hand, JPMorgan Securities turned positive on mortgages, but cautioned that the outlook could shift quickly from here. Higher rates could pressure MBS on the increased convexity hedging, but they are also likely to attract increased buying from banks and from overseas, analysts said. They prefer to stay up in coupon with an underweight in 5%s.
Mortgage Application Activity Falls
The Mortgage Bankers Association reported a decline in application activity for the week ending June 22. Activity was expected to be lower given the level of mortgage rates. In that week, Freddie Mac reported 30-year fixed mortgage rates at 6.69%.
The Refinance Index was off 2.5% to 1731.6 - its lowest level this year - while the Purchase Index declined 4.9% to 428.9. A year ago, the indices were at 1499 and 415, respectively, with mortgage rates in the 6.70s. As a percent of total applications, refinancing share rose to 38.7% from 38%. ARM share was essentially unchanged at 20.4% versus 20.3% previously. The MBA also reported that the 30-year fixed contract rate held unchanged at 6.66%.
Prepayment Outlook
Prepayment speeds in June are expected to hold nearly unchanged in 6% coupons and lower, while 6.5s are predicted to slow around 5% from May. Slightly stronger seasonals are seen as offsetting the lower day count. Declines of roughly 10% on average are predicted for July. Day count holds unchanged at 21 days; however, higher interest rates and the decline in application activity is expected to have a significant impact on prepayments. In August, speeds are expected to be around 5% higher than in July as the number of collection days increases by two, to 23.
For the remainder of this year, analysts from UBS believe that the prepayment trend will be for slowing speeds assuming mortgage rates remain in a higher range than they are in currently. Influencing the slowing speed outlook are: weak seasonality after August that will slow down housing turnover, which has a larger effect on discount coupon prepayments, weak HPA that will reduce cashout refinancings and that tends to influence speeds on par and premium coupons, as well as the higher rate levels that will affect speeds across the coupon stack as the refinance incentive is very small.
Credit Suisse analysts noted that only 4% of outstanding MBS are currently in the money.
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