Annaly/FIDAC Monthly Market Commentary: June 2005
(posted 7/8/05)

FOCUS

• The Mortgage Market : Option ARMs make houses affordable but the market anxious
• The Economy : The housing market continues its strong performance
• The Markets : Oil and gold are up strongly, but where is inflation?

The Mortgage Market

Mortgage prepayment speeds increased slightly in May (reported in June) for fixed-rate mortgages, which was in line with expectations. However, speeds on hybrid ARMs increased by 12 to 15%, which was more than expected. Looking forward, June prepayments (reported in July) are expected to increase by 15 to 20%. Prepayments should continue this upward trend through the summer as the recent rally of the 10-year US Treasury to under 4.00% has sparked an uptick in refinancing activity. As rates remain at these low levels a pickup in refinancing activity can be expected. The MBA Refinancing Index has certainly reflected this as it has recently posted levels close to 3000 and has averaged over 2600 for the last 4 weeks. This is well above the average for the year of 2170.  Nevertheless, UBS mortgage research still estimates that a sustained 10-year yield of under 3.65% would be needed for prepayments to reach the levels seen in 2004, when the Refinancing Index hit 5000.

The popular press has devoted an extraordinary amount of time and worry to the slew of alternative mortgage products that have come to define today’s robust housing market. The most popular, and perhaps most risky, of these products has been Option ARMs (also known as Negative Amortization Arms). An Option ARM typically provides the borrower with four choices each month:

1. The minimum payment, which can start as low as a 1.0% pay rate, and allows  for negative amortization, or in other words a growing principal balance.
2. An interest-only payment, which is the payment necessary to keep the loan balance constant and not negatively amortize.
3. A payment of interest and principal that would amortize the loan over a 30 year period.
4. A payment of interest and principal that would amortize the loan over a 15 year period.

The most enticing of these options is the minimum payment option because of its extremely low payment amount.  However, because this option allows for the loan to negatively amortize it also has the most potential to cause credit problems for the borrower. This innovative mortgage has become very common over the past few months as the mortgage banking community has addressed the challenge of closing the gap between the relatively steep climb in house prices and the relatively flat growth in personal incomes. Thus, they have been used as a way for a borrower to stretch his or her affordability levels.

However, as mentioned above, such products do not come without increased risk. We believe such products have increased the amount of credit risk in the mortgage market, especially if interest rates rise or house price appreciation trends lower. It is for this reason that we have stayed away from purchasing such assets. It also worth noting that the GSEs, whose mortgage-backed bonds we purchase, have been reluctant to significantly enter into the Option ARM arena. For example, according to Lehman Brothers’ research, Freddie Mac has been very selective in taking on such mortgage products, as it has only accounted for 3% of their business this year.  

The Economy

The month of June ended with an anticlimactic 25 basis point increase in the Fed Funds rate. For all the market’s hand-wringing, editorializing and pundit pronouncing during the month (“When Will He Stop?” blared the June 27 cover of Barron’s), the Fed did exactly what it telegraphed it would. As we have said for months, without a change in the FOMC statement in May, the market should not have expected any variation in its current policy in June. And since there was virtually no change in the June 30 statement, the market should not expect any variation in Fed policy at its August 9 meeting. So prepare yourselves for another 25 bp hike, the 10 th in as many meetings since June 30, 2004 . A change in policy will loom only when the Fed tells us in its policy statement that the balance of risks of price stability and growth are no longer equally weighted but tipping towards slow growth and low inflation.

Another item breathlessly discussed in recent weeks has been the hot housing market. Indeed, US home prices set an all-time record in May as the median home sales price set a record of $207,000, and home sales continue at near record pace: Existing homes were on an annual pace of 7.13 million and new home sales were on an annual pace of 1.298 million, both the second highest readings ever. To us, the housing market is indeed strong but we would argue that its strength is derived not from any intrinsic increase in the value of the house. Rather, it is a by-product of exceptionally low interest rates and easy access to cheap capital. (Another way to say this is that if long-term interest rates rise, the market will cool down.) Nevertheless, this by-product has played a powerful part in the strength of the US economy, as mortgage financing has also helped fuel consumption in the US. Are we in a bubble? We’ve written about this before, and still stand by the conclusion we drew in our piece on bubbles and the housing market (“A housing bubble? Not like the South Seas,”): “We have to remember that the average homeowner still has significant equity in his or her house and that the housing market does not move at the same speed as the stock market or the tulip market. If there is any conclusion at the end of this thought process, it is this: There are many edges to the sword of MBS, and some of those edges work in our favor. Unlike unsecured investments, ours are secured and, at that, secured by a basic element of human existence. Geographical diversification protects the MBS investor.”

We are still watchful of the potential effect that a slowdown in the rate of growth of, or even a decline in, housing values might have on portfolios of Agency mortgage-backed securities. From a credit perspective, we feel confident in the ability of Fannie Mae and Freddie Mac to withstand a decline in housing values, were that to occur. We say this for a few reasons. First, each company undergoes significant stress testing procedures, which include replicating the worst local boom/bust performance in the US. Second, the loan size limits and credit standards that go into qualifying borrowers for inclusion in Fannie and Freddie programs lead to better credit performance for mortgages in the pools issued and guaranteed by those entities. Third, there is significant equity underneath the mortgages in the Agency portfolios. Freddie Mac reports that at December 31, 2004, the weighted average loan-to-value of its single-family mortgage loan portfolio at origination was 70%, and that the current marked-to-market LTV of its portfolio is 57%. According to Freddie Mac, defaults are less likely to occur on mortgages with lower estimated current loan-to-value ratios, which in any event would have more equity to mitigate any credit losses. (See the Commentary portion of our website for a more complete discussion of this topic: “We take virtually no credit risk”.)

The Markets

During June, stocks went sideways, but refinancing activity picked up as long rates stayed low. Gold and oil, reflecting and causing inflation, respectively, both rose. Conundrum indeed.

This commentary is neither an offer to sell, nor a solicitation of an offer to buy, any securities of Annaly Capital Management, Inc. (“ Annaly”), FIDAC or any other company. Such an offer can only be made by a properly authorized offering document, which enumerates the fees, expenses, and risks associated with investing in this strategy, including the loss of some or all principal. All information contained herein is obtained from sources believed to be accurate and reliable. However, such information is presented “as is” without warranty of any kind, and we make no representation or warranty, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use. While we have attempted to make the information current at the time of its release, it may well be or become outdated, stale or otherwise subject to a variety of legal qualifications by the time you actually read it. No representation is made that we will or are likely to achieve results comparable to those shown if results are shown. Results for the fund, if shown, include dividends (when appropriate) and are net of fees. ©2005 by Annaly Capital Management, Inc./FIDAC. All rights reserved. No part of this commentary may be reproduced in any form and/or any medium, without express written permission.