Mortgage spreads firmed up on Wednesday as Treasurys sold off prompted by another round of supply worries. These market jitters resulted from the vague details of President Barack Obama's housing plan.
Lower coupons were substantially tighter - even in the face of more than $2 billion in supply - while higher coupons were weaker because of the increased prepayment risks associated with the latest plan.
There is still a lot about the housing program for the MBS market to digest, and even its haste to move down in coupon was a bit of a knee-jerk reaction based on traditional thinking. At the moment, it is very unclear how much the plan will alleviate problems in the housing market and to what extent credit-impaired borrowers will be helped and how soon. The Federal Open Market Committee (FOMC) downgraded its outlook for the economy - which further added uncertainty to how much benefit the housing market will receive from the plan.
The FOMC's revised forecast now projects GDP to contract up to 1.9% in 2009 compared with a previous expectation of up to 1% growth. It also estimates unemployment to reach as high as 8.8% versus the low to mid-7% area projected in October.
Minutes from the January FOMC meeting highlighted the committee's concerns regarding an economic turnaround this year, and the best case is for some improvement to begin showing late in 2009.
Refinancing Activity Jumps
Mortgage application activity jumped 45.7% in the week ending Feb. 13 in response to lower mortgage rates. The Mortgage Bankers Association reported that the average contract interest rate for 30-year fixed mortgages declined 20 basis points to 4.99%. This is the lowest level since the week ending Jan. 9, when it fell to 4.89%, which pushed the Refinance Index 26% higher to 7414.
In this latest drop below 5%, the Refinance Index surged 64.3% to 4472.9 following a 30% plunge in the previous week as mortgage rates jumped. Meanwhile, the Purchase Index rose 9.1% to 257.3.
As a percent of total application activity, refinancing share increased to 74.2% from 66.7% previously. ARM share fell to 1.7% from 2.5%.
Mortgages outperformed Treasurys month-to-date through Feb. 17, according to Barclays Capital. Excess return on the MBS Index was 59 basis points compared to negative 163 basis points on the ABS Index, negative 72 basis points on CMBS and 39 basis points on corporates.
MBS analysts' tone was more weighted toward neutral on the mortgage basis last week. For example, Bank of America Securities turned neutral on the mortgage basis versus Treasurys. Analysts found only limited upside in the sector for several reasons, such as somewhat tighter mortgage spreads. They also noted the potential for a sharp rate backup from current levels, causing mortgage market convexity to worsen and implied volatility to rise. If rates rally strongly, mortgages will also not be able to keep up with Treasurys because of the limited upside in MBS prices, the increased risk of domestic bank selling of agency MBS, the attractive valuations in alternative sectors and the uncertain overseas demand. Overseas demand could dip because of the declining U.S. trade deficit, lower petrodollars and Asian domestic fiscal stimulus programs.
Deutsche Bank Securities analysts were also neutral on the mortgage basis amid concerns of increased bank selling if the mortgage market reaches a $103-16 level and limited declines in volatility based on economic uncertainty. Credit Suisse analysts also mentioned hedging challenges, spreads near the tight end of their recent range and challenges in a rally - which kept them neutral.
Barclays Capital, however, remained overweight on the basis due to the Fed's presence in the MBS market and the belief that the call risk that is being priced into the market is overdone.
There have been upward revisions in the past week by some Wall Street analysts to February's prepayment outlook. Speeds are now projected to increase slightly over 20% with paydowns estimated in the mid-$90 billion area. Speeds initially had been estimated to increase about half as much. The largest percentage increases in terms of vintage are 2008, by coupon in 5s and 5.5s and also in 6s for GNMAs. The 6.5%s are estimated to increase between 11% and 13%; on 7% vintages, FNMAs are estimated to increase around 18%, while GNMAs are projected to slow in 2007 and 2006 vintages while increasing 21% in 2008. March and April, conventional speeds are expected to slow less than 10%, while GNMAs are projected to increase modestly in both months.
Credit Suisse analysts commented on the lack of response on seasoned vintages, specifically in 2003 to 2005. They believe "fundamental factors such as differences in average loan balance, WAC and SATO explain a significant portion of the differences in response between newer and seasoned vintages." As a result, they think slower prepayment speeds on seasoned vintages will likely persist.
However, prepayments on credit-impaired agency MBS could begin to increase under the Treasury's financial stability plan. Prepayments for these loans would be a negative for mortgages, noted Deutsche Bank analysts, and also negative for the banking sector, "since higher prepayments along with new low-coupon origination would serve to reduce net interest margins," they said.
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