- The Mortgage Market : Prepayment speeds fell slightly, should pick up in the short term but ease thereafter
The Mortgage Market
Aggregate fixed-rate and hybrid ARM mortgage prepayments came in lower than expected for the month of January (February reporting period), posting speeds that were 5 to 10% lower than expectations and 20 to 30% less than December’s numbers. Most likely, large winter seasonal effects weighed down refinancing volumes more than expected for the month of January. Thus, dealer forecasts are looking for a pickup in prepayments for February and into the spring months as seasonal slowdowns abate and the lower rates of early February work their way through the system. Nevertheless, we still do not anticipate any unexpectedly large uptick in prepayments over the coming months given the recent backup in US Treasury yields and the 10% decline in the MBA Refinancing Index to below 2300.
As expected, Fannie Mae continues to be a fixture in the headlines for 2005 as they released that their regulator OFHEO had approved their plan to increase capital by September 2005 (an extension beyond the original deadline of June 2005) and that there are further accounting practices under review for possible irregularities. . Unlike Fannie Mae’s equity price, which has been on a steady decline recently, debt spreads on Fannie Mae mostly shrugged off the news and were tighter for the month by a few basis points. Further, such headlines continue to have a limited effect on mortgage spreads, even though Fannie Mae has reduced its portfolio growth significantly. In January Fannie Mae reported a 16.8% annualized decline in its retained (i.e., on-balance sheet) portfolio. While putting some pressure on spreads, market participants see that the potential negative impact of reduced demand by Fannie Mae is likely to be somewhat offset by strong demand from other MBS buyers and lower issuance of MBS in 2005. It can be argued, therefore, that the market has separated Fannie Mae’s accounting and regulatory woes as negative for stockholders but positive for debt holders. This is clearly seen in the accompanying graph, which shows Fannie Mae’s stock price steadily declining, whereas debt and mortgage spreads have been on a tightening trend. Although we cannot be certain about the outcome of these Fannie Mae issues, we still believe that MBS continue to be the premier asset-backed security in the world, fully collateralized by residential homes and supported by the mortgage payments of the homeowner, significant equity cushion in the house, insurance and the rights of foreclosure. As always, we will continue to monitor the situation, ignore the noise, and carefully look for investment opportunities.
The Economy
Unlike the Chairman, we don’t believe that there should be too much confusion over why longer-term interest rates are staying in a tight trading range, the month-end sell-off notwithstanding. Chalk it up to enduringly strong demand by foreign investors for US securities, particularly Treasurys and Agencies; purchases of longer maturity paper in advance of proposed pension reform; mortgage hedgers buying longer-duration paper to hedge prepayment risk; excessive risk-taking as a consequence of more transparent Fed policy; reaching for yield in a low-return market environment; low comparative rates of return for securities issued by other sovereign issuers around the world; or just simply a reflection of low expectations for inflation and growth in the US. It is difficult to delineate which reason, if any, dominates the market at any one time, but all of these are influencing the long end of curve. (Certainly, if the Treasury chose to issue more 10-year notes or renewed issuing 30-year bonds, then the pressure on the long end would be eased.)
On the other hand, we can identify several reasons why the long end of the yield curve should be higher, all other things being equal. The current account deficit continues to deepen, which has prompted the US Treasury to adopt an unstated policy of benign neglect of the dollar. The weaker dollar would typically result in a shift in trade balances, higher import prices and related inflationary pressures as well as higher interest rates to compensate investors for the declining value of their dollar-based investments. The budget deficit continues to deepen, a condition that bespeaks a worsening credit profile for any issuer and thus relatively higher rates. A significant budget deficit such as we have now in the US is typically accompanied by a steep yield curve. Last, four years of accommodative monetary policy, including one year at the 1% “emergency” Fed Funds rate, as well as the ever-rising price of oil, have planted the seeds for an inflation that is starting to be seen in the official data, including the latest PPI and PCE numbers.
With these competing forces for range-bound rates and higher rates, why is range-bound winning the day? In the case of the declining dollar, consider that some of our most significant trading partners, including China and Japan, have either explicit or implicit pegs to the US dollar. To keep their pegs or trading ranges, then, these partners have to buy more dollars as quickly as its value slips. These dollars get reinvested into dollar-based assets, mostly Treasurys and Agencies, keeping interest rates down but also not helping to make much of a dent in the trade deficit. In the case of inflationary expectations, consider that for all of these concerns inflation is still relatively low, even with soaring oil costs. The bond market seems to have been ignoring oil, although oil above $60 a barrel may be harder to ignore. In addition, each “measured” increase of 25 bp in the Fed Funds rate moves us closer to the neutral rate which should further temper growth expectations.
Where we come down on the debate is of little consequence to our portfolio, as we do not take an explicit position with regard to the direction or magnitude of interest rates. Instead, we attempt to compile a portfolio that will be able to perform in a wide range of interest rate environments. That said, we do believe that the Fed will continue to march up the Fed Funds rate at a measured pace but will watch closely for any changes in message or action. The next Federal Open Market Committee meeting takes place on March 22.
One thing of which we are certain, however, is that credit spreads remain inexplicably tight. As the graph describes, through January the Lehman High Yield Index and the Lehman Aggregate Index, which encompasses the universe of investment grade bonds, are at or near their narrowest spreads to Treasurys. Specifically, the High Yield Index is trading at a spread of 267 bp above Treasurys, or a yield of 7% and an average dollar price of 103.4, while the Lehman Aggregate is trading at spread of 82 bp above Treasurys at an average yield 4.4% and a dollar price of 104.8. Credit market participants have to ask themselves, where is the upside in that?
