Annaly/FIDAC Monthly Market Commentary: December 2005
(posted 1/6/06)

FOCUS

• The Mortgage Market : Prepays continue to slow; watching Fannie Mae and Freddie Mac
• The Economy : The Fed rings a bell; looking ahead to 2006
• The Markets : The year was not kind to stocks or bonds; the Refi index falls

The Mortgage Market

For the month of December mortgage prepayment speeds are expected to follow in November’s footsteps as dealers expect a decrease of 5% to 10% in speeds for fixed-rate and adjustable-rate mortgages. This slowdown reflects the slower seasonal factors affecting mortgage originator activity and an overall trend towards a slowing housing market relative to 2004. As a testament to slowing refinancing activity, the MBA Refinancing Index at the end of December was 1363, a level that is 20% lower than a year ago and 35% lower than the average reading for 2005. As we enter 2006, it will be important to discern any further slowing trends and the impact that may have on the mortgage market in terms of extension risk and spreads.

Now that 2005 is in the record books we look back at some of the dominant themes in the mortgage market and the new trends that will undoubtedly develop in 2006. Mortgage originations in 2005 remained strong, with approximately $2.8 trillion through November, with the potential to be the third best year on record. Sparking this volume was a further expansion into alternative/affordability loans via such borrowing vehicles as Interest Only and Negative Amortization loans, and continually low mortgage rates. According to HSH Associates, a New-Jersey-based consumer finance research house, the average 30-year fixed mortgage rate for 2005 was 6.00%, just a 4 basis point increase from 2004’s average and 1 basis point higher than the 2003 average. As we look towards 2006 most expectations call for a slowing origination market with a re-focus on more traditional lending products such as 30-year fixed-rate mortgages because of the flatter and higher Treasury curve environment. Yet, with housing affordability coming under pressure we expect to still see a fair amount of affordability products, such as 30-year fixed rate mortgages with a 10-year interest only term, in order to keep the marginal homebuyer in the market.

We also anticipate 2006 will be a year where the focus on the consumer balance sheet is intensified as the housing market slows. While we will not be too worried about any potential stress in consumer credit in terms of defaults for Agency MBS, we will need to be alert to how such events may affect prepayments and spreads.

Fannie Mae and Freddie Mac remained in the headlines during 2005 with the accounting woes at Fannie Mae leading the way. As a result of pressure to meet required capital levels following an accounting restatement, Fannie Mae’s retained portfolio declined by over $175 billion, or 20%, from $905 billion in December 2004 to $716 billion in November 2005. At the same time, Freddie Mac, not facing the same issues saw its retained portfolio grow $40 billion, from $653 billion to $693 billion. See the graph below. While spreads on Agency MBS versus the 10-year Treasury have widened during the year, we would argue that higher long-term rates, the flattening curve and extension concerns have had a greater effect on spreads than the change in the combined portfolios of Fannie and Freddie, as other investors, particularly foreign investors have stepped up to meet supply.

In 2005, the debate continued in Congress over a new regulator with new powers for the Government Sponsored Enterprises, but there was no resolution. The main sticking point between the House proposal and the Senate’s is whether to put in portfolio investment and size constraints. We expect to see a resolution to these debates in 2006, but even though we think the impact will be relatively benign, we will be keeping a close eye on any regulation that would cause the GSEs to begin any large portfolio reduction campaign.  

The Economy

The FOMC statement released after the December 13, 2005 meeting (at which the Funds rate was increased by 25 bp for the 13 th consecutive meeting to 4.25%) signaled that a change in policy was in the offing. Since the Fed began affecting transparency, we have maintained that the Fed would tell us, through the FOMC statement, when it was going to change policy. This approach by the Fed was maddeningly simplistic for a market that thrives on uncertainty, but it has held true. In each of its previous statements during this tightening cycle, the Fed had concluded that it considered monetary policy to be accommodative, and would thus continue to raise rates at “a pace that is likely to be measured.” In the December 13 statement, however, the Fed indicated that it had achieved interest-rate neutrality by deleting the conclusion that monetary policy was accommodative, although it did say that “some further measured policy firming is likely to be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance.” This change, minor as it may seem, is as close as the Fed will get to ringing a bell that it is almost done.

There will be an end to the tightening soon, but the debate now turns to how many more before the end. The minutes of the meeting, released on January 3, 2006, seemed to suggest that the Fed, facing uncertainty, would rather tighten than do nothing. “Views differed on how much further tightening might be required,” the minutes said. “Because the Committee’s actions over the past 18 months had significantly reduced the degree of monetary policy accommodation, members thought that the policy outlook was becoming considerably less certain and that the policy decisions going forward would depend to an increased extent on the implications of incoming economic data for future growth and inflation….[T]he number of additional firming steps required probably would not be large.”

We’ll take the Fed at its word. We believe that a raise to 4.5% at the January 31 meeting is certain. The likelihood of another rate hike at meeting after that, scheduled for March 28, is less certain but will be highly dependent on data coming out over the next three months. High on the list of statistics the Fed will be watching are those that will signify potential inflationary pressures, including high energy prices and tightness in “resource utilization” data such as employment, wages and capacity utilization. The Fed will also watch those variables that would tend to contain inflation, including the ability of companies to absorb costs, productivity, robust competition among domestic and foreign producers, and the waning of Katrina-related stresses. On the growth side, the trends in consumer spending, the auto sector and, especially, housing will be watched. On the last point, while the Fed observed that housing activity seems “somewhat less ebullient,” it curiously noted that “the national data on home prices, sales, and construction activity did not suggest a significant weakening in the sector.” Presumably by the March 28 meeting the Fed will have noticed that inventories of unsold homes is at an all-time high, months of supply is rising, sales for existing and new homes is declining, and mortgage activity for new purchases and for refinancing is subsiding dramatically.

We’d like to think that the discussion over the likelihood of a March 28 rate hike will be the result of an objective review of the statistics and a consideration of what is best for the future of the US economy, but there is a wild card that bears at least a mention. The January 31 meeting will be the last meeting over which Alan Greenspan will preside, and the March 28 meeting will be the first one chaired by his presumptive successor, Ben Bernanke. (Bernanke has not yet been confirmed but there is virtually no doubt about the outcome.) Some have suggested that Bernanke will need to prove his inflation-fighting credibility by continuing what Greenspan started. With the significant change in language in the December 13 FOMC statement suggesting that the current level of interest rates is at or near neutral, the minutes’ specific discussion of the number of additional tightenings that may be needed, and the possibility that the January 31 statement will contain further signals that the tightening cycle is at an end, it appears that Greenspan hopes to hand over the reins to Bernanke without boxing him into continuing a policy that is already in place. Even though Bernanke is respected by the financial markets, it would have been much more difficult for him to convince the market that the policy Greenspan had set in motion should be changed. Just like only Nixon could go to China, only Greenspan can change Greenspan’s policy. Thus, perhaps by engineering this shift, Greenspan’s parting gift to his successor is that he will able to make his decision on March 28 by the data alone.

Looking back on 2005 and ahead to 2006, the main observation we would make is that the specific investing challenge of 2005—the incessant climb of the short end of the curve with a rangebound long end—will be over, possibly in the first quarter. The driver of the short end volatility was the monetary policy decisions of the Federal Reserve, and the driver of the Fed’s policy was a reversal of the emergency deflation-fighting of 2002-2003 that eased the Fed Funds rate to 1%. That is ending. It is less clear to us that the conditions that drove the relative long-end stability are ending, but perhaps in 2005 the market applied a too-small risk premium to that possibility. To us, the lack of long-end volatility, as well as the continuation of relatively tight credit spreads across the credit markets, has been caused by an abundance of liquidity and global savings continuing to pour into what is perceived to be the high quality duration of the Treasury market (and, to a lesser extent, the Fed telegraphing its intentions and a lack of any real economic surprises). This is a condition that is prone to changing in unpredictable ways. We don’t believe global liquidity and capital flows are going to change much, but the greater risk in 2006 is that the risk premiums associated with longer duration assets will rise which, as Alan Greenspan warned in his speech at Jackson Hole in August, could be painful. “[H]istory,” he said, “has not dealt kindly with the aftermath of protracted periods of low risk premiums.” The risks associated with long-term rates in 2006 are not that different than 2005: the potential for much higher (or much lower) oil prices, structural budget and trade deficits in the US, a weaker dollar, the appetite of foreign investors for dollar-based investments, the appetite of China for all commodities, and the ever-present geopolitical risks of the modern world.

Much of the action of the long end of the bond market will be driven by the performance of the US economy. Risks to economic performance will likely be to the downside, particularly once the lagged effects of past rate increases work through the economy. If we can trust the historical predictive track record of the shape of the yield curve, then the flatness of the curve presages a slowing if not outright recession by the end of 2006. Most economists, however, are still calling for relatively strong economic performance in 2006. The average forecast for quarterly annualized growth during 2006 in the December Bloomberg survey of 66 Wall Street economists was 3.1%, 3.1%, 3.0% and 3.0% for each quarter. For us, we will be watching the US consumer. In the middle of the 20 th century, when US manufacturing was the envy of the world, General Motors was the largest corporation in the world with over half the car market in the US. GM’s chairman Charlie Wilson famously told a Senate investigative committee, “What’s good for GM is good for the rest of America.” Clearly, times have changed. Today the saying should be “What’s good for the US consumer is good for the global economy.” There is nothing new analytically in being worried about the US consumer, and these concerns have been around for a while. Nevertheless, we note that for the first time since the Great Depression, in 2005 Americans spent more than they earned, resulting in a negative savings rate. When a company or a person has negative cash flow, they stay in business by borrowing, although in the US this is referred to using the more politically correct “equity extraction through cashout refinancings.” This trend is expected to slow as interest rates rise, housing affordability declines, home sales slow down and equity extraction is reduced as a source of disposable cash. In addition, more and more Americans are exposed to more and more interest rate risk than ever before. As a result, we expect that two things may happen. First, credit cracks begin to appear, which could ripple through to the fixed income markets. Second, American consumers lose confidence and slow down their consumption. The graph below, showing the relationship between consumer confidence, the change in consumer spending and GDP growth, illustrates why we will be watching.

The Markets

US stocks had a weak year, as did short duration fixed income. Long-term rates around the world are drifting downward, and the dollar is strengthening as the Fed has continued its tightening policy. Gold, oil and other commodities had strong years. The MBA Refi Index has declined 19.9% in 2005 as mortgage rates have risen.

Source: Bloomberg

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