NEW YORK--(BUSINESS WIRE)--
Annaly Capital Management, Inc. (NYSE: NLY) released its monthly
commentary for August which includes an update on developments in
Washington as well as a review of the economy and the residential
mortgage, commercial mortgage, corporate credit and Treasury markets.
Through its monthly commentary and blog, Annaly
Salvos, Annaly expresses its thoughts and opinions on issues and
events in the financial markets. Please visit our website, www.annaly.com,
to check out all of the new features and to view the complete commentary
with charts and graphs.
Washington Update
Washington continues to dominate the attention of the financial markets.
The Dodd-Frank Wall Street Reform and Consumer Protection Act was signed
into law on July 21. Rather than signaling the end of a long legislative
process, the signing ceremony ushered in the beginning of a long
regulatory rulemaking process. A lot of work remains to be done, with an
estimated 243 rulemakings and 67 studies delegated to regulators. Much
remains unresolved on many important items, such as the Volcker Rule
requirements, swap business pushout rules, bank capital requirements,
risk retention and which firms would be considered systemically
important, so firms and participants are attempting to quantify the
costs of compliance. Others are considering getting ahead of the
regulators, i.e., reports on Goldman Sachs spinning out its principal
trading teams and Morgan Stanley reducing its stake in FrontPoint
Partners. This will continue to take time and effort by a wide range of
constituencies, but it stands to reason that implementation will be
limited until the rules are settled.
One item that is conspicuously absent from Dodd-Frank is GSE reform. We
have no issue with its absence, as the tenuous state of the housing
market precludes any serious change to the housing finance system at
this time. Moreover, there is little activity in the American mortgage
market outside of Ginnie Mae, Fannie Mae and Freddie Mac, with virtually
no private label securitization taking place (due to uneconomic pricing
and related rating agency policies). Nevertheless, the issue remains
high on the agenda of policymakers and the discussion is in full swing.
The Department of Treasury had requested public input on the housing
finance system in the US, and received over 400 responses from a wide
range of market participants. Annaly Capital Management submitted
a response, in which we made the following main points:
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The key to overhauling housing finance in America is to understand
what was broken, then keep what worked and discard what didn’t.
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What did work? The current housing finance system (certainly the one
that prevailed outside of the mortgage credit bubble) is the most
efficient and scalable credit delivery system the world has ever seen.
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Thanks to securitization, the government guarantee and the
connection between primary mortgage borrower and secondary market
investor that is facilitated by Fannie Mae and Freddie Mac. These
are features worth keeping.
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What didn’t work? The Agencies’ retained portfolio activities and poor
underwriting standards in the broader mortgage marketplace.
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The private market can replace the portfolio activities as long as
there is a dependable funding market, and policymakers should
focus on incentivizing and enforcing robust underwriting practices
for both rentals and homeownership.
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The market will adapt to whatever policy objective comes out of
Washington, most likely by repricing the risk, uncertainty and
friction of whatever replaces the current system. The consequences of
change are that the size, scope, availability and efficiency of the
current housing finance system will change as well. If the new system
is significantly different than the housing finance system we have
now, the consequences may be that our housing finance system will be
smaller, perhaps more appropriately priced, but with lower housing
values and less flexibility and mobility for borrowers.
Treasury has planned a conference on the topic to be held on August 17
(Annaly will be in attendance), and the House Financial Services
Committee, which has already held a number of hearings, has called for
its next one to be held in September. Treasury has pledged to have its
proposal for housing finance reform complete by January 2011, so the
process will undoubtedly pick up speed in advance of that deadline. Stay
tuned.
The Economy
The data flow during the month of July painted a relatively weak picture
of the economic recovery. Measures of consumer confidence declined,
retail sales disappointed, durable goods orders softened, and the
employment situation continues to frustrate us. Initial unemployment
claims, though distorted recently by seasonal adjustment factors, remain
stubbornly over the 450,000 line on average. Nonfarm payroll data for
July was generally weak. A favorite leading indicator for the path of
total jobs, temporary help, turned negative for the first time in nine
months. The private sector added a total of 71,000 jobs, but the real
story here is that state and local governments are shedding jobs at such
a rate that they are offsetting much of these mild private sector
employment gains. Besides the federal government shedding around 143,000
census jobs, state and local governments shrunk their payrolls by
roughly 48,000. Since September 2008, state and local governments have
cut 316,000 jobs, with more than half of those in the last seven months
alone. Ongoing budget issues at the state and local government level
suggest this will continue to be a headwind.
If, as it appears, the effect of fiscal and monetary stimulus is fading,
it is no surprise that the baton is being passed to the Federal Reserve.
Throughout its history, the Federal Reserve could respond to economic
weakness by lowering short-term rates. But with the Federal Reserve
Funds rate effectively at zero, Chairman Bernanke & Co. have moved down
the checklist of alternative policy moves outlined in his seminal deflation
speech back in 2002, most of which are related to the Federal
Reserve balance sheet. As the graph, available in our online
version, demonstrates, the structure of the balance sheet
accommodation has changed over time, as the needs of the system and the
Federal Reserve’s goals have changed.
Early in the financial crisis, Federal Reserve efforts were devoted to
stopping the bleeding, providing liquidity to those who needed it, and
helping markets function. The “Other” line above represents line items
like the commercial paper funding facility, liquidity swaps, and the
holdings of the Maiden Lanes, Aurora LLC, and ALICO Holdings. Later the
focus shifted to asset purchases, primarily of Agency MBS. As this $1.25
trillion flowed through the markets, and in conjunction with various
financing facilities (TALF, etc), spreads tightened in every sector.
Given how wide credit spreads were at the time, this strategy was
justifiable. Spreads that wide crimp borrowing and serve as a drag on
the economy. This is a new kind of Federal Reserve policy: If borrowing
rates don’t follow the Federal Reserve Funds rate down, the Federal
Reserve can use its balance sheet in a variety of ways to make it
happen. This requires a new type of analysis by the Federal Reserve (and
Fed-watchers) to expand beyond rates and spreads to take into account
the actual borrowing levels both from banks and the capital markets.
This means we should be watching money supply.
Whether or not the Federal Reserve is actually paying attention to money
supply, it is behaving as if it were watching the money supply. This is
what we read between the lines in articles like the recent Wall
Street Journal article touting a possible “symbolic shift” in
Federal Reserve balance sheet management to reinvesting cash flow from
the existing portfolio of Treasuries and mortgage-backed securities.
Thanks to this runoff, the balance sheet at the Federal Reserve has
recently begun to shrink, as can be seen in the graph in our online
version. There is much debate over how this run-off will be handled,
and we believe the market is prepared to adapt to whatever the Federal
Reserve decides to do. The fact of the matter is that a shrinking asset
portfolio at the Federal Reserve is a de facto tightening. With a sub-3%
10-year Treasury, mortgage rates at historic lows, Target Corp (TGT)
able to borrow for 10 years near 4%, and IBM selling one-year paper at
1%, Federal Reserve policy is more likely focusing on money supply than
rates. When the Federal Reserve buys assets, it creates reserves at
banks. In normal times, the banks would then take those reserves and
lend them out, putting that new money out into the economy. This is the
relationship that the money multiplier shows. But the problem for the
Federal Reserve is that it controls the monetary base (including
reserves) but it doesn’t control broad money supply. The normal
mechanism isn’t working, excess reserves are sitting at the Federal
Reserve, and loan portfolios at the banks continue to shrink. The
Federal Reserve needs a new playbook.
The Residential Mortgage Market
The month of July ended with contract mortgage rates remaining at
historically low levels, as 30-year fixed-rate conforming mortgages
averaged 4.60% and 15-year conforming rates dipped to 4.03%. Despite
such low levels, prepayment speeds excluding the GSE delinquency buyouts
have yet to gain any traction. Prepayment speeds (measured as Constant
Prepayment Rate, or CPR, which is the percentage of principal that is
returned on an annualized basis in a given month), in June (July
release) for 30-year Fannie Mae MBS dropped 38% from the previous month,
from 28.1 CPR to 17.5 CPR, as their buyout program came to an end.
Freddie Mac, whose buyouts were completed back in March, reported speeds
19.4% faster, up from CPR of 14.4 to 17.2. Speeds in July (August
release) for 30-year Fannie Mae MBS increased 6% to 18.5, while Freddie
Mac speeds for the month increased 14.5% to 19.7.
If refinancing behavior were based on rates alone, then prepayment
speeds would normally be much faster. Consider the graph, available in
our online
version, courtesy of Barclays research. During most of the past
decade, the CPR of borrowers who are 100 basis points “in the money” for
a lower rate was about 50 to 60. In other words, from 2000 to 2008 50%
to 60% of borrowers who had the opportunity to lower their mortgage rate
by 100 basis points would have refinanced. In 2009, however, only 20% to
25% of borrowers who are 100 basis points “in the money” took advantage
of the lower rate, behavior that is more common when there is no
particular rate incentive at all. In past commentaries we have reviewed
the reasons why refinancing behavior currently is atypically slow, so
suffice it to say that we expect refinancing speeds will stay this slow
until banks regain their footing, negative equity issues are resolved or
credit trends generally improve.
Which brings us to the latest chatter in the residential mortgage space:
There has been speculation that the government is planning to break this
refinancing logjam by eliminating all underwriting standards such as
income verification, FICO requirements and LTV restrictions and quickly
refinance all GSE-owned mortgages down to current mortgage rates. The
speculation picked up speed after it was suggested as a possibility by
some Street research and picked up by reputable news sources. In general
the market barely blinked at the story, but the Treasury took the
unusual step of refuting it. “The administration is not considering a
change in policy in this area,” said Treasury spokesman Andrew Williams.
We can see the attraction of the simple outline of the rumor: Instant
stimulus without needing Congressional approval, a win-win for a party
facing a tough mid-term election. In any event, there are already plans
like this in place under HAMP and HARP.
Leaving aside the moral hazard involved (the lender has no
responsibility under a mortgage agreement to protect the downside risk
of home prices falling just as the homeowner has no obligation to share
any upside with the lender), the rumored plan doesn’t hold water. First,
the potential savings amounts—about $46 billion per year, according to
the economics team at Morgan Stanley—is not insignificant, but it is not
without cost. The actual process of refinancing itself would constitute
a large capital call on banks needing to refinance the mortgages.
Furthermore, to the extent that Fannie Mae and Freddie Mac are taking
steps to protect taxpayers—through putting back mortgages that were
improperly underwritten or suing issuers of fraudulent private label
securities—a refinancing program like this would completely undermine
that effort. If there are no underwriting standards as part of a
refi/stimulus plan under the GSE umbrella, the government would
essentially be guaranteeing unknown collateral. This idea is nothing
more than an interesting hypothetical thought exercise.
On August 6 the FHA released more details on a previously announced
program to facilitate short refis into an FHA loan. The program, said
FHA Commissioner David Stevens, is a “lifeline out to those families who
are current on their mortgage and are experiencing financial hardships
because property values in their community have declined.” Starting Sept
7, 2010 the FHA will offer certain non-FHA borrowers the opportunity to
qualify for a new FHA-insured mortgage as long as they are FHA eligible
and their lenders agree to write off at least 10% percent of the unpaid
principal balance of the first mortgage. Importantly, participation is
voluntary by the lender. Barclays concluded the program will affect
private-label securities but estimates that the program will “have a
very modest impact on overall loss assumptions (and home price
forecasts) due to the low expected eligibility.”
The Commercial Mortgage Market
Slowly, multi-borrower, mixed collateral CMBS transactions have been
getting some traction since the late spring. To date, three transactions
totaling $1.8 billion have been sold. The two most recent of these, one
sponsored by JP Morgan Chase (JPMCC 2010-C1) and the other by Goldman
Sachs (GSMS 2010-C1), included below-investment grade bonds at the
bottom of the capital stack. Aside from the usual questions on pricing
levels and collateral quality, investors have also focused on new
control rights and actions for certain certificate holders. This month,
we’ll examine highlights of some new control features in these
transactions.
As previously reported in our February 2010 commentary, an investor in
the lowest-rated certificate—provided the certificate had a least 25% of
its initial face amount outstanding—was the Directing Certificate Holder
who was responsible for approving special servicer recommendations.
Unrealized losses had no impact on the certificates. Once a
certificate’s balance was wiped out through realized losses, however,
the Directing Certificate Holder rights were passed on to the next class
outstanding. An unintended consequence of these structures was the
potential to anoint investors in very, very thin bond tranches as the
Directing Certificate Holder. This potential outcome led investors to
the calculus of which tranche would be the ‘fulcrum bond’ of the deal in
different scenarios, thereby enabling that tranche to become the
Directing Certificate Holder.
New control features were introduced in June with the JPMCC 2010-C1
transaction that had elements of the existing CMBS structures. First,
approval rights would initially be granted to the B piece buyers. Thus,
change of control abilities would be established at the outset and
limited to subordinate investors. Second, a change of control occurred
not only with realized losses but with unrealized losses through
appraisal reductions as well. The latter mechanism enabled the removal
of zombie entities that had no further economic upside by holding the
position. Finally, a ‘Control Event’ concept was introduced which meant
that if losses, realized and unrealized, wiped out the initial B piece
buyers and junior participants then a new Directing Certificate Holder
would then be selected by senior certificate holders. This mechanism
clearly aligned the remaining economics of the deal with the senior
certificate holders, the majority of which would be AAA.
In late July, the GSMS 2010-C1 transaction introduced another
significant change-in-control feature. Simply, the most junior investor
no longer had the ability to appoint or direct the actions of a special
servicer in the event a loan went bad. From the outset, this right was
conveyed to the most senior certificate holders who are the largest
investors in a deal. Also a deal website that provides the status and
updates on specially serviced loans was provided. Given changes that
senior certificate holders have been recommending to revamp CMBS
structures, this was certainly a win for them. However, as we have noted
before, working relationships are not always as smooth as envisioned.
To us, these changes reflect the balance of power in CMBS
securitizations. First, structurers are clearly listening and reacting
to investors’ concerns about control features and special servicing, as
worst-case outcomes have pushed the envelope of the traditional
structures and found them wanting. Of course, time will tell whether
these new control features represent a better solution for dealing with
problem loans and the resultant conflicts. Second, there is significant
demand for the higher yielding opportunities of the mezzanine and junior
tranches. Perhaps the new features are no more than a solution to the
difficulty in placing AAA bonds yielding below 4%.
The Corporate Credit Market
Risk appetite has returned to the corporate credit market. Several
catalysts underpin the change. First, the European bank stress tests
proved to be a relative nonevent as only a handful of institutions
tested were deemed undercapitalized in the stress scenarios. Second, US
financial regulatory reform was finally signed into law by President
Obama. Third, the BP oil spill appears to now be under control and firms
affected have a better handle on the cost of the disaster and are
prepared to take action. And fourth, the Q2 2010 earnings season is
shaping up without a hitch. Hence, with certain fears allayed or at
least defined, “liquidity” has once again become the driving force
behind valuations.
Moving in sympathy with the Treasury market, investment grade corporate
yields have dipped to a historic low of 3.94%, based on Bank of America
Merrill Lynch’s index (see graph in our online
version). Declining yields have propelled 2010 total returns to an
impressive 8.3% year-to-date. But today’s low yield underscores the
increasing risk asymmetry of the asset class going forward. Average
dollar prices have climbed to a lofty $110.20 and the effective duration
of the market has is now a record long of 6.42 years. Increasingly, a
“Japan Scenario” is embedded in pricing.
Investment grade spreads are now at their annual tights, having fully
retraced the Spring sell-off. Q2 earnings revealed that banks’ top-line
revenue was sluggish, but overall earnings were buoyed by reserve
release, providing more evidence of managements’ belief that the
cyclical peak in credit losses has passed. Moreover, several banks
stated intentions to spin off certain lines of business, proactively
addressing the Volcker Rule. Improving balance sheet credit quality and
lower risk-taking are good things for bank credit and spreads narrowed
accordingly. Issuers satisfied improved investor demand by selling new
paper, propelling 2010 supply in the financials category to over $100
billion, an 80% year-over-year increase in volume.
Further down the credit spectrum, the high yield sector has performed
in-sync with its investment-grade counterpart. This year’s returns are
pacing at 8.4%, compared to equities’ 1%. Declining default losses are
supporting the sector. The default rate continues to march lower,
dropping to 5.5% vs. the cycle peak of 13.5% last November. Moody’s
recently lowered its year-forward default expectation to a mere 1.8%. To
put this rate of loss number in a return context, at current market
pricing it translates into an implied one-year excess return of 7.5%
assuming a 40% recovery rate. Contributing to lower default expectations
is capital markets liquidity. Namely, the new issue market has once
again reopened, allowing issuers to roll short-term debt and exchange
bank debt for longer-term bond debt. Furthermore, high yield companies
are deleveraging; debt leverage has declined a quarter of a turn (0.25x)
to 4x for companies in Morgan Stanley’s high yield universe over the
past two quarters. The technicals of the high yield market are also
stable; fund flows have marked their fourth straight inflow week after
the spring’s net outflow period.
In contrast, flows into leveraged loans mutual funds have lost their
robust start-of-year momentum. Over the past two months, the annualized
pace of inflows has dropped by over 50%. One of the biggest drivers of
this change is likely changing perceptions of the path of LIBOR, the
rate on which most leverage loans are indexed. Increasingly, the tepid
nature of the expansion and the likelihood that the stickiness in the
high unemployment rate is due to structural factors has fostered a
growing perception that the Federal Reserve funds rate will remain at 25
basis points for the next couple of years, keeping a low tether to
LIBOR. The effect on income for loan product has been depressing: at
4.25% YTD total returns are running half of those of high yield bonds.
The Treasury/Rates Market
The Treasury market seemed unstoppable in July as prices marched higher
and yields fell. Even a rally in stocks off their lows of the year and a
move higher in other “risk” assets couldn’t push Treasury prices lower
as increased talk of a Japan-like deflation scenario started to seep
into the market. The two-year Treasury reached an all time low yield for
a second month in a row with a rate of .55% on July 30. It has since
briefly breached the half-percent mark.
The Treasury sold $173 billion in notes and bonds in July, down $5
billion from June. Demand at auction time was varied across maturities.
The three-year, seven-year, and 10-year note auctions saw tepid end user
demand as indirect and direct bids were on the weaker side. Demand was
stronger in the two-year note and 30-year bond auctions as bids were
more consistent with previous auctions. The five-year note auction was
the best of the month as end-user demand was particularly strong with
combined indirect and direct bids totaling 58.7%, the strongest since
April.
The strongest demand in the market in July was focused in the five- to
seven-year sector of the Treasury curve. One of the main reasons behind
the buying continues to be Federal Reserve maintaining the “extended
period” language in FOMC statements; market players thus are emboldened
to take advantage of the yield roll down that part of the curve.
Secondly, as mentioned earlier, economists (most notably St. Louis
Federal Reserve president James Bullard) have started to compare the
current rate environment in the US to Japan in the late 1990s when the
Bank of Japan’s policy moves did little to prevent a deflation scenario.
In Chart 1, available in our online
version, we see the yield on the 5-year JGB since 1995 along with
Japan CPI figures. You will see how yields dipped below 1.5% in 1997 and
have yet to move above that level (Yields are currently under .40%).
Chart 2, available in our online
version, shows the same data for the 5 year UST Bond where yields
are approaching the same 1.5% level which is one reason for the Japanese
deflation talk that has become so prevalent lately.
We will know more in five years whether the US is following in the
footsteps of Japan. Yields have been steadily moving lower since April
and all eyes will be on the Federal Reserve for clues on what tools they
choose to use to manage the situation.
August 10, 2010
Jeremy Diamond*
Managing Director
Robert Calhoun
Vice President
Frederick Diehl
Vice President
Mary Rooney
Executive Vice President
*Please direct media inquiries to Jeremy Diamond at (212)696-010
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. ©2010
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 our express written permission.
Source: Annaly Capital Management, Inc.