FOCUS
Prepayment speeds for July (reported in August) came in slower than expected for fixed-rate and adjustable-rate mortgage-backed securities, with fixed-rate speeds increasing only 2 to 3% and adjustable-rate speeds coming in flat to slightly lower. Looking forward, speeds are expected to increase for August as the low rate environment of late June and early July works its way through the mortgage pipeline. In addition, there is typically a seasonal increase in prepayments around this time of year. Speeds may start to abate into the fall of 2005, however, given the recent rally of the 10-year Treasury to around 4.00% it is unclear how much speeds will decrease during the September and October periods. As always, we will be keeping a close eye on the MBA Refinancing Index, which measures refinancing application activity, in order to discern prepayment trends going forward. The index currently stands at about 2357, which is below the trailing 3-month average of 2456.
Given the damage that Hurricane Katrina has caused to states bordering the Gulf of Mexico, it is important to understand the effect such a disaster may have on holders of Agency MBS. Foremost, it is essential to know that for the Agency MBS holder any uninsured defaults in the area would flow through as prepayments because Agencies guarantee the timely payment of principal and interest. Typically, loans that are affected by natural disaster remain in Agency pools, and mortgage servicers are required to advance scheduled principal and interest payments. That being said, we would expect MBS securities with high concentrations in the affected Gulf states to actually prepay slower during the recovery period as the hurricane has undoubtedly wiped out any transactions that would have otherwise taken place during a normal business environment (i.e., sales or refinancings). Once the area begins to rebound we may see an uptick in prepayments from those states. Nevertheless, on a broader level the impact of Hurricane Katrina on the Agency MBS market is likely to be small. According to JP Morgan research estimates, the states most affected by Katrina— Louisiana, Alabama and Mississippi—make up only about 3.5% and 2.1% of Fannie Mae and Freddie Mac-issued MBS, respectively.
At the end of August, Freddie Mac reported results for the first half of 2005. Management guided to lower net interest margins in 2005 due to the operating conditions affecting all financial institutions. At the same time, they also confirmed that they are now current with their financial disclosure and on track to report quarterly results on a timely basis. Further, management indicated that the Company is in compliance with its regulatory capital requirements. We view these latter two events as a positive for MBS and debt investors as clarity regarding their balance sheet will only continue to increase, and because of the confirmation that their capital strength remains intact.Most of the economic data released during the month was generally supportive of current monetary policy: On August 9, the Fed moved up the bank overnight borrowing rate by 25 basis points for the 10 th consecutive meeting, to 3.5%. CPI, PPI and the PCE indexes were all up. Productivity for the second quarter was weaker than expected and unit labor costs rose by the most in almost five years. In his testimony before Congress last month, Fed Chairman Greenspan said that higher labor costs, combined with rising energy prices and low long-term interest rates, were a threat to price stability. Consumer spending rose again in July, as people spent more during the month than they earned through income, dividends and government payments, pushing the personal savings rate in the US to below zero. Enticing the spending spree was the heavy discounting in the auto sector (which also helped to hold down inflation).
At the same time, the Institute for Supply Management manufacturing index fell to 53.6, which was below expectations, industrial production rose a less-than-expected 0.1% and factory capacity utilization declined. Durable goods orders fell by 4.9% in July, reflecting a decline in demand for aircraft and technology equipment. With every increase of the Fed Funds rate, policymakers and investors are evaluating the potential for an economic slowdown. According to the latest Bloomberg survey of 57 Wall Street economists, released on September 9, the median estimate for GDP growth is 3.1%, 3.4% and 3.3% in the 4 th quarter of 2005 and the first two quarters of 2006, respectively. Clearly, consensus opinion has been that the current track of Fed policy is not going to cause a recession, but the shape of the yield curve indicates that the bond market has faith in the Fed’s ability to curb inflation.
Did Katrina change all that? Perhaps in the short term. The Congressional Budget Office estimated that Katrina will reduce GDP growth by 0.5% to 1.0% in the second half of 2005. Prior to Katrina, the consensus for 4 th quarter GDP according to the Bloomberg Survey was 3.5%. Additionally, whereas prior to Katrina there had been virtual unanimity among economists AND the market that the Fed would raise rates on September 20, perception has shifted. The Wall Street Journal conducted a survey of economists in which 15 economists said the Fed should stop its rate-raising policy while 35 said to stay the course. As we discussed in our last Monthly Commentary, at the end of July the futures market was pricing in a Fed Funds rate of 4% by December (two more raises); after Katrina the market expects 3.75% by year-end (one more raise).
Katrina is certainly going to reverberate even after the winds subside and the waters recede. The United Nations has said that in terms of damage to homes and businesses, Katrina may turn out to be the most costly natural disaster ever. For the US, Katrina will likely be the most expensive disaster in history. Federal relief efforts alone top $60 billion, easily exceeding the $20 billion cost of Hurricane Andrew which hit southern Florida in 1992, and they are likely to go higher. This expenditure will deepen the Federal budget deficit. Estimates of economic loss have exceeded $100 billion. Prices are up across the petroleum complex as the storm cut by more than half the energy production in the Gulf of Mexico, which accounts for about a third of the oil and a quarter of the natural gas consumed in the US. Energy prices, which heretofore have not had a significant impact on consumer prices, could begin to take their toll on underlying inflation and economic growth if they continue to rise. Overall, however, while the short term dislocations are considerable and the sheer human toll of Katrina has been devastating, her long-term economic impact is likely to be modest. Pipelines and production will be repaired. The ruined cities will be rebuilt and people relocated. Despite the catastrophic impact of Katrina on the local and national economy, and on the financial markets, we doubt that current Fed policy will deviate much, if at all, from its current course.
We also do not expect that the events of the last two weeks changed Alan Greenspan’s main preoccupation as it relates to the economy and his legacy. That preoccupation was expressed clearly (for him) in his speech at a symposium sponsored by the Federal Reserve Bank of Kansas City in Jackson Hole, Wyoming on August 26. “The rising prices of stocks, bonds and, more recently, of homes … is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.”
Of all the markets he cited, the housing market in particular has been a concern of Chairman Greenspan. And rightly so. On September 1, the Office of Federal Housing Enterprise Oversight (OFHEO) released its quarterly report on trends in housing price appreciation. From the second quarter 2004 to the second quarter of 2005, average US home prices increased 13.43%, the largest year-over-year increase since the second quarter of 1979 (when CPI was approximately 11%).
The home price appreciation was fairly broad-based. Nevada and Arizona were the states with the highest year-over-year increases, at 28.1% and 27.8% respectively. Twenty-five states (including Washington, DC,) exhibited double-digit annual price growth. OFHEO’s chief economist, Patrick Lawler, said, “The continue price increases are a result of many factors, including low mortgage interest rates and the apparent impact of speculative investing....However, they are likely unsustainable given the underlying inflation rate, income growth and other factors.” It is not only the prices that are high, but the turnover as well. In fact, we think the housing market may be nearing or past its peak (absent some new lows in long-term rates). Evidence of this is that ARM originations are declining and that while existing home sales are setting new records, so is the supply of homes for sale. According to the National Association of Realtors, in July there were 2.75 million homes for sale, the most since May 1988.
Perhaps Greenspan’s strategy of slowing down the housing market (and puncturing the debt bubble) by raising rates is working. We point out, however, that since 1976 there has never been a year-over-year decline in the value of the average US home. We also note that the OFHEO report delineates the breakdown between conforming and non-conforming loans for California, which is a good proxy for states that have a high degree of home price appreciation. (So-called conforming loans acquired for inclusion in the Fannie Mae or Freddie Mac pools of mortgages can be no more than $359,650.) In 2002, nearly half of the loans acquired by the Agencies in California were for houses that were at or below the conforming loan limit. By the second quarter of 2005, only one-third of those acquired mortgages were for houses that were at or below the conforming loan limit. In San Diego, 41% of the homes were at or below the conforming loan limit in 2002 and just 6% by the second quarter of 2005. Thus, the fastest appreciating areas have largely priced themselves out of the conforming program of Fannie Mae and Freddie Mac. Notwithstanding this fact, Agency MBS holders should take comfort in the many levels of protection that they have behind the Agency guarantee, including the income of the homeowner, the credit work in qualifying the homeowner for the mortgage, the value of the home and the equity in it, as well as insurance and the rights of foreclosure. Moreover, in what could be a positive development for our strategy, we would expect that a decline in the value of homes to dampen so-called “cash-out refis”, where a refinancing is used for equity extraction.The Markets
The fixed income market rallied across the board in August, primarily due to the knee-jerk reaction to Katrina. Specifically, the rush to the short end of the curve reflects the immediate assumption that the Fed would pause or stop in pursuing a tightening policy. The 2-year Treasury which had risen in yield by 38 bp in July, rallied by 20 bp, or about half a point in price. Stocks were modestly lower and oil set new highs.
31-Aug-05 |
31-Jul-05 |
31-Aug-04 |
MOM % change |
YOY % change |
|
Federal Funds Rate |
3.50% |
3.25% |
1.50% |
7.7% |
133.3% |
2-year US Treasury |
3.815% |
4.019% |
2.395% |
-5.1% |
59.3% |
10-year US Treasury |
4.016% |
4.278% |
4.119% |
-6.1% |
-2.5% |
10-year JGB |
1.349% |
1.313% |
1.544% |
2.7% |
-12.6% |
10-year euro |
3.100% |
3.243% |
4.019% |
-4.4% |
-22.9% |
10-year UK Gilt |
4.159% |
4.315% |
4.923% |
-3.6% |
-15.5% |
10-year Canadian govts |
3.789% |
3.869% |
4.605% |
-2.1% |
-17.7% |
30 yr conventional mortgage |
5.61% |
5.63% |
5.55% |
-0.4% |
1.1% |
Dollar Index |
87.58 |
89.35 |
88.94 |
-2.0% |
-1.5% |
Japanese Yen |
110.69 |
112.29 |
108.89 |
-1.4% |
1.7% |
S&P 500 |
1220.33 |
1234.18 |
1104.24 |
-1.1% |
10.5% |
Nasdaq Composite |
2152.09 |
2184.83 |
1838.10 |
-1.5% |
17.1% |
Gold $/oz (nearby contract) |
$435.10 |
$429.90 |
$410.90 |
1.2% |
5.9% |
Oil $/bbl (nearby contract) |
$68.94 |
$60.57 |
$42.12 |
13.8% |
63.7% |
MBA Refi Index (month-end value) |
2357.10 |
2250.30 |
1804.10 |
-2.8% |
21.3% |
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.