Annaly/FIDAC Monthly Market Commentary: October 2005
(posted 11/9/05)

FOCUS

• The Mortgage Market : Prepays slow in October; the House passes new GSE bill ; Fannie Mae meets its capital goal
• The Economy : A new Fed Chairman is nominated; the Fed stays on its measured course
• The Markets : Energy prices moderate; rates rise across the curve

The Mortgage Market

For the month of October mortgage prepayment speeds decreased for fixed-rate and adjustable-rate mortgages as higher rates and a shorter business day count tempered mortgage refinancing activity. As we enter the fall/winter months, higher mortgage rates and slower seasonal factors are expected to lower prepayment speeds further. The MBA Refinancing Index is reflecting this anticipated slowdown, as it now stands at 1863, which is about 13% lower than the 3-month average of 2151. We will be paying very close attention to whether this expected slowdown is just the usual seasonal noise or if it reflects a slowing in the overall housing market going forward. Typically a slowing housing market would imply sustainable lower prepayment rates relative to the recent past. Also, lower prepayments would precipitate extension fears and likely lead to spreads on mortgage-backed securities to widen. We have experienced some of this spread widening in the MBS sector recently as the 10-year Treasury yield increased by 23 bps during October.    

Fannie Mae and Freddie Mac were back in the headlines in October. The House of Representatives passed their version of the GSE regulatory reform bill.  In general, the House bill calls for the creation of a new regulator that would have the power to bar the GSEs from new business lines and place them under receivership in the event of default. It also has a requirement that 3.5% of their after-tax profits be allocated to a fund for affordable housing. However, the bill does not include any portfolio size limits. Thus, it is unlikely that this legislation will be enacted prior to year-end because the Senate’s version of the bill calls for specific portfolio limits. These limits address the concerns of Fed Chairman Greenspan and the White House that the GSEs are too large. We expect the debate surrounding the portfolio limits to continue into 2006.

In related news, OFHEO, the current GSE regulator, announced Fannie Mae reached the 30% capital surplus target that had been imposed because of the accounting restatement process that is under way. To meet this requirement, Fannie has had to shrink its portfolio by $177 billon year-to-date. Most market participants are hoping that by meeting its capital surplus target, Fannie signals an inflection point for shrinkage in its portfolio and that the company will slowly come back to the market.

The Economy

Market participants got clarity on at least one question this month: Ben S. Bernanke will step into the very large shoes of the soon-to-retire Alan Greenspan as the new Chairman of the Federal Reserve in January, pending his expected confirmation by the US Senate. Bernanke is an academic who has spent the last three years in government service, most recently as the Chairman of the President’s Council of Economic Advisors and before that as a governor of the Federal Reserve Board. Prior to that he headed the economics department at Princeton University. In general, the bond and the stock markets have reacted calmly to the idea of Bernanke as the new leader at the Fed. He’s a known commodity with an extensive body of work on macroeconomic policy and monetary policy, with a focus on studying the Great Depression.

While the market knows who will be the new Fed Chair, it now is focusing on what kind of policymaker he will be. In this regard, several of his intellectual touchstones have come under scrutiny. Dr. Bernanke first garnered attention beyond the halls of academia when, in November 2002, he delivered a speech that became the basis for the Fed’s deflation-fighting policy. In “Deflation: Making Sure ‘It’ Doesn’t Happen Here,” Bernanke essentially argued that the Fed would take any steps necessary to stave off deflation, including non-traditional policy tools. These tools, such as fomenting inflation by cranking up the currency printing press or buying back Treasurys, are a viable alternative as interest rates neared the zero bound because, as he said, “Sustained deflation can be highly destructive to a modern economy and should be strongly resisted.” The following year, Bernanke gave a speech entitled “A Perspective on Inflation Targetting,” in which he spoke admiringly of the track record of central banks around the world which practice the policy. Bernanke has also been a vocal proponent of transparency and clarity in communicating the Fed’s approach to monetary policy. As it relates to the Fed’s ability to influence market expectations, he said last year that “the [FOMC] statement has become an increasingly important tool of policy.” These speeches and his other writings have been combed over as the market has tried to evaluate the future Bernanke-led Federal Reserve. Will he be an inflation dove or a hawk? Will he continue the policies of Alan Greenspan? Will he be independent?

We will likely get some clues to Bernanke’s approach going forward during his confirmation hearings (not yet scheduled, but likely during November). In the meantime, though, the Fed Funds futures market is generally expecting the Fed Funds rate to be increased by 25 bp at each of the remaing two meetings that will be overseen by Alan Greenspan. We have no special insight into what Bernanke will do once in office. In his nomination press conference, Bernanke stated, “My first priority will be to maintain continuity with the policies and policy strategies established during the Greenspan years.” We take that to mean that he will not be dogmatic or ideological in his approach, although his style will certainly be different—more transparency in his speeches and official Fed statements. Instead, we believe, he will focus on the data. Thus, the question that the market must think about is what kind of economy is Bernanke inheriting? Certain aspects of the economy are solid. The Institute of Supply Management reported strong non-manufacturing and manufacturing results for October, with strength in employment and prices paid. The first estimate of third quarter GDP came in at 3.8%, higher than consensus, and core inflation moved mostly sideways, while headline numbers (which include the more volatile food and energy components) rose. The core PCE, which has been identified as the Fed’s preferred measure of inflation, rose 2.0% on a year-over-year basis through September, at the high end of the so-called comfort range. On the other hand, we note weakness in housing and consumer spending, both important data series for the US economy going forward. Real consumer spending fell by 0.4% in September following a 1% decline in August, portending slowing spending in the fourth quarter. Spending on both durables and non-durables fell in the month, which offset small gains in consumption of services. Inventories of unsold homes are rising, mortgage rates are rising, mortgage refinancing activity is declining. The graph below, showing the last five years of mortgage rates for ARMs and 30-year fixed-rate mortgages as well as the months of supply of new homes for sale, illustrates those trends.

The Markets

Yields in the fixed income market rose across the board in October, with almost a basis point for basis point shift upward in 2s and 10s. Stocks finished the month down slightly, the dollar strengthened, and oil prices continued to retreat. The MBA Refi Index continued to decline, reflecting the higher rate environment.

October was a continuation of the unfavorable market conditions we have been discussing in recent commentaries. These market conditions adversely affect our results in two ways. First, our spread is compressed as our cost of funds continues to rise relative to the yield on our assets. Second, the transition to a flat curve with the short end rising as the long end stayed range-bound pressured asset prices and enables prepayment speeds to stay relatively fast.

Our strategy has operated through tightening cycles before, but no two markets are the same. Table 1 summarizes the period of June 1999-2000, when the last Fed tightening took place, and the current cycle. A close look at the table will demonstrate that, from June 1999 to June 2000, nominal interest rates were much higher: the change in Fed Funds from 4.75% to 6.5% was a 175 bp tightening and a change of 37%; today’s tightening regime has brought rates up 300 bp or 300%. Refinancing speeds were much lower: At the beginning of the last tightening cycle, in June 1999, the MBA Refi Index was 612.20, and in June 2004 it stood at 1386.9

There were other differences related to macro conditions, but perhaps the most important as it relates to our strategy is the duration of the tightening cycle. In 1999-2000, the tightening cycle lasted 13 months. Today’s tightening cycle is at 18 months and counting. It will likely last at least another two 25 bp tightenings, which would bring Fed Funds to 4.50% by January 31, and it may go further once Bernanke takes over. This level for the Fed Funds rate is beyond the initial expectations of the market, as Fed officials themselves had indicated that the 3.75% to 4% range was the target (i.e., Dallas Fed President Fisher’s now-infamous “8 th inning” call). The sell-off in the bond market since that expectation was changed, particularly in the short end, has been dramatic.

Table 2 shows the composition of the largest sector of the mortgage market (fixed-rate pass-throughs, 30-year and 15-year) and how it has changed through the various markets. You’ll notice that the weighted average price of the market in June 2003 was 103.11 as compared with 97.66 today. Interestingly, while it took a full year of Fed tightenings to move the price from 101.18 in June 2004 to 99.28 in June 2005, the marked change in expectations for Fed Funds that occurred this past summer has resulted in a rapid decline to today’s 97.66.

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.