Annaly/FIDAC Monthly Market Commentary: September 2005
(posted 10/11/05; edited 10/14/05)

FOCUS

• The Mortgage Market : Prepayments expected to slow; Assessing the “new” news at Fannie Mae
• The Economy : Despite Katrina, Fed raises rates again; Greenspan takes on housing
• The Markets : Rates rise across the curve, the short end leads the way

The Mortgage Market

For the month of September mortgage prepayment speeds increased in line with expectations for fixed rate and adjustable rate mortgages as the low rate environment of early July worked its way thru the mortgage pipeline and there was an increase in business day count. As we enter the fall, prepayment speeds are expected to abate somewhat as day count drops and slower seasonal factors take hold. In addition, with the recent move up in the 10yr yield to around 4.35% mortgage rate refinancing incentives have become less, which should slowdown prepayment rates in the coming months. Therefore, most dealer expectations are currently calling for a 10-15% slowdown over the next few reporting periods. The MBA Refinancing Index, the preferred measure of mortgage refinancing applications, is beginning to reflect this trend as its most recent reading of 2107 is well below the 3 month average of 2347.

As the September 30th deadline approached for Fannie Mae to meet a 30% capital surcharge, a Dow Jones article raised concerns that further accounting restatements could be possible, suggesting that investigators have “unearthed widespread problems and GAAP violations…that run much deeper and effect a far greater portion of the company’s assets.” On this news the stock initially traded down over 10.5% and is currently down 5.1% from its price prior to Dow Jones story. However, unlike the move in Fannie Mae equity, spreads on Fannie Mae MBS and Agency debt barely moved as MBS spreads were mostly unchanged and debenture spreads widened only a basis point or so. Despite the rather large move in the equity price, the stability in the MBS and debt spreads could be a reflection that the news was essentially a non-event for Fannie Mae MBS and debt. After all, OFHEO, Fannie Mae’s regulator, came out on the same day saying that "Based on current assessments of accounting deficiencies and estimates of other potential impacts to capital, OFHEO anticipates Fannie Mae will meet the capital target." Thus, it can be argued that any additional restatements would be relatively small and would not affect Fannie Mae’s ability to meet their capital surcharge requirements. However, even if the financial impact suggested by these headlines turns out to be miniscule, the news may have an effect on the debate in congress over increased regulation and a new regulator. Of course we will be monitoring the situation going forward.

The Economy

The Federal Reserve chose to view Hurricane Katrina as a temporary, exogenous event—in purely economic terms—and raised rates during September. Once again, for the 11 th straight FOMC meeting, the Fed concluded that its monetary policy is still accommodative. The specter of inflation, while still contained, remains a concern, thus the FOMC reiterated its belief that “policy accommodation can be removed at a pace that is likely to be measured.” There was a difference this meeting, however, in that there was doubt about the Fed’s intentions due to Katrina. Indeed, for the first time since June 2003, there was a dissenting vote among the Fed voting members, (when Robert Parry wanted a 50 basis point cut instead of 25 bp). In addition, the Fed spent a considerable amount of words in its FOMC statement talking about the devastation of Katrina, perhaps so that it would not seem unfeeling and remote from the human suffering even as it continued to raise rates along its previously proscribed path. But raise it did, and given the text of the FOMC statement and some recent hawkish speeches given by other Fed governors, the Fed will likely raise rates at the next meeting as well, to be held November 1. This tightening is largely priced into the market already.

In thinking about the future course of Fed action, which has a direct effect on our cost of financing, there are two broad topics we consider. First, we examine whether the Fed’s monetary policy is generating classic cause and effect as it relates to the economy. Specifically, is inflation contained through raising the price of credit, which would dampen economic growth and ultimately restrain demand for goods and services? Second, are the actions of the Fed having any effect on what seems to be its main preoccupation of late—the housing market? As it relates to the economy, we would argue that Fed policy—and oil prices, too—is having an effect on the consumer, which accounts for roughly two-thirds of the US economy. US personal spending fell in August by the most in over three years and income dropped, in data compiled before Hurricane Katrina. September data will likely look worse as it reflects post-Katrina devastation. In addition, while existing home sales surged in August, new home sales sold in August unexpectedly plunged 10% to the slowest pace since November 2004. Oil prices are frequently cited as the explanation for rising default and delinquency problems in credit cards. The American Bankers Association reported that delinquency rates for credit card bills hit an all-time high in the second quarter, as the share of accounts that were 30 or more days past due grew to 4.81% from 4.76% in the linked period. In explaining the record, the ABA cited "financial stress" caused by rising energy costs, among other factors. Energy prices are getting to the point where even George Bush is trying to change consumer behavior. In a speech on September 26, President Bush said, “We can all pitch in by being better conservers of energy…We can curtail non-essential travel.” To us, this seems like a statement that is made on the brink of a contraction, reminiscent of the energy crisis of the late 1970s when President Carter called on all Americans to wear sweaters rather than heat their homes too much.

Delta Air Lines and Northwest Airlines, the third and fourth-largest carriers in the US, both declared bankruptcy in September. In Europe, the European Union is worried about the poor economic performance of its member countries, particularly their budget deficits, and the IMF has expressed the shared belief that the “especially high and volatile oil prices” will have a significant impact on growth and inflation. While Alan Greenspan has talked about the “conundrum” of low long term rates during a tightening phase, we believe that there may be another conundrum to consider—the possibility that the tightening phase of the interest cycle would be followed by slow or recessionary economic growth but that this would also be accompanied by inflationary pressures due to high oil prices.

For all that is going on in the economy, Alan Greenspan seems to be spending his remaining months in office talking down the housing market. On September 26 he gave a speech to the American Bankers Association in which he discussed his concern over some of the new mortgage product innovations which have enabled marginal borrowers to buy ever more expensive houses. “The dramatic increase in the prevalence of interest-only loans, as well as the introduction of other, more-exotic forms of adjustable-rate mortgages, are developments that bear close scrutiny. To be sure, these financing vehicles have their appropriate uses ….[These products] are seen as vehicles that enable marginally qualified, highly leveraged borrowers to purchase homes at inflated prices. In the event of widespread cooling in house prices, these borrowers, and the institutions that service them, could be exposed to significant losses.” At the same time, Mr. Greenspan reminded his audience that the most egregious activities are still occurring in localized markets and that the “vast majority of homeowners have a sizeable equity cushion with which to absorb a potential decline in home prices.” He also suggests that a decline in the value of housing might not be an unwelcome development, as it would likely spur increased saving and likely help improve the current account and trade deficits.

Mr. Greenspan puts the blame for the rise in mortgage debt and housing price levels on the right culprit—low long-term interest rates. Since long-term interest rates and mortgage rates are actually lower today than when the Fed started tightening in June 2004, it would seem that despite its best efforts the Fed has had little effect on the housing market. Thus Mr. Greenspan has been engaged on a program of aggressive speechmaking to make his point. But has the Fed been ineffectual, or has the free market begun to take care of the problem? The graph below illustrates that perhaps we are nearing a change in tone in the housing market. The National Association of Realtors index of housing affordability for first time home buyers, which stands now at 70.1, is the lowest it’s been since before the last recession. The index measures whether or not a typical family could qualify for a mortgage loan on a typical home. To interpret the index, a value of 100 means that a family with the median income has exactly enough income to qualify for a mortgage on a median-priced home using a 20% down payment. We also show the ratio of home prices to income in the US (multiplied by 100). It’s the highest ratio since 1979. Can housing prices continue their dramatic rise relative to income? As the economist Herbert Stein famously said, “If something cannot go on forever, it will stop.”

The Markets

Yields in the fixed income market rose across the board in September as post-Katrina economic numbers, Fed rhetoric and demand–supply imbalances in the energy markets sparked inflation concerns and raised expectations for more Fed rate hikes. The short end of the curve experienced the brunt of the sell off reflecting the immediate assumption that the Fed may need to pursue more of a tightening policy. The 2-year Treasury, which had rallied by about 20 bps in August, sold off by 35bps for the month of September. Stocks finished the month slightly higher and oil retreated somewhat from new highs.

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