MBS War Room - Revisiting the Interest Rate Outlook by Adam Quinones

by 12 Apr 2010

In my last column I discussed the outlook for interest rates in 2010. The basic premise of the forecast was: DONT EXPECT 2009 RATES IN 2010

The general logic behind the anticipated rise is: barring a sudden contraction in economic activity, the worst-case financial scenario has likely been avoided. 
Several factors can be cited as a source of rising rates, but only few can be mentioned when trying to argue for lower rates.
This position is based upon the assumption that while housing is stagnate and the labor market is far from full health, global governments and central banks have formed strategic alliances to ensure financial panic is prevented from spreading. All official attention is focused on stimulating an innovative recuperation and long-term recovery.
The road ahead wont be smooth though. Negativity and pessimism will remain uncomfortably abundant for some time. There will be ups and downs from month to month. Progress will be jagged.
The only real fix for this crisis is time. Everyone needs time to recover. Confidence, credit, and consumption all must be restored one step at a time. Eventually we will all get used to the new normal, as PIMCO puts it.
There is positivity embedded in this projection though. Re-allocating retirement funds and life savings into riskier assets (stocks) will not be an easy decision for nervous Main Streeters. Risk aversion will stay in style. Demand for the safety of US Treasury securities will remain firm.
While rate sheet influential bond yields should benefit from this general lack of investor confidence and conviction, the days of 2009 are behind us and benchmark interest rates are not expected to return to those levels.
Without going into servicing valuations and best execution options, mortgage rates are dependent upon the mortgage basis.  The current coupon mortgage basis can be generally thought of as a guidance giver for mortgage rates.
In the months ahead, the movement of mortgage rates will be a factor of:
  1. The direction and movement of benchmark Treasury yields
  2. The perception of risk in holding mortgage-backed securities as an investment (loss of principal investment)
  3. Supply and Demand in the agency MBS market
The first part of the equation, the direction and movement of benchmark Treasury yields, is a factor of Federal Reserve interest rate policy expectations, stock sentiment, and the political tone regarding the budget deficit.
The second part of the mortgage rates equation, the perception of MBS and GSE debt investment risk, is almost entirely a function of the political developments surrounding Fannie Mae and Freddie Mac. 
While the GSEs remain under the care of the FHFA and US Treasury, lets not forget, by all measures both institutions are insolvent, and in the absence of the governments intervention and their semi-explicit guarantee, they would be unable to function normally.  At some point their issues will have to be dealt with.
The unknown status of the GSEs (and the health of their portfolios) will add risk to investing in agency MBS and agency debt.  That perception of risk will manifest itself via higher mortgage rates relative to benchmark yields (wider yield spreads).
The third part of the mortgage rates equation, supply and demand in the TBA MBS market, is a bit more complicated.
Since refinance activity peaked in mid-2009, we have observed a progressive slowdown in loan production.  Michael Fratantoni, MBAs VP of Research and Economics, summed up the mortgage environment perfectly:

Although rates remain low, there appears to be a smaller pool of borrowers who are willing and able to refinance at todays rates.
On the refinance front, demand will be low as most qualified borrowers already refinanced at record low rates while others are still happy to let their ARMs reset at index plus margin (LIBOR still near record lows) This leaves the focus on purchase apps.
The mortgage bankers association expects loan production to slow at least 40% in 2010 (from 2009).
Based on basic supply and demand theory, if loan production is slow and new MBS supply is muted, less investor demand will be required to stabilize secondary market liquidity and MBS valuations.
So while mortgage rates are expected to rise due to political uncertainty surrounding the GSEs and generally higher benchmark Treasury yields, the increase may be less than expected thanks to favorable supply/demand technicals in the secondary mortgage market.
This assumes the Federal Reserve has carried out their plan to exit the secondary mortgage market (I wrote this on Feb.24). It also assumes a stable source of demand will step up to replace the Feds supportive bid in the TBA MBS market.
There are several candidates who are able to assume this role, but they are not likely to do so without reward.
Domestic and international banks are a proven resource.  Adding confidence to that outlook is the fact that the Federal Reserves MBS purchases have left the banking system in a highly liquid condition, with U.S. banks still holding more than $1.0 trillion excess reserves at Federal Reserve Banks.  These are funds that need to be put to work via lending.
In 2009, hedge funds and money managers were net sellers of current coupon mortgage-backed securities. In 2010 it is anticipated these accounts will become more neutral market participants. Assurance of this theory was offered when Fannie Mae and Freddie Mac announced in February that they would purchase substantially all seriously delinquent loans from their respective mortgage-backed security pools. These purchases will return principle investment to MBS holders, this is cash that will be available for reinvestment in cash market MBS coupons.
While we are hopeful private investors will step up when the Fed exits the secondary mortgage market, we know it will come at a cost.
Investors will wait for MBS valuations to cheapen before becoming consistent buyers again. Cheapen as in rate sheet influential MBS coupon yields will widen against benchmark Treasury yields.
As of February 24, 2010, the secondary market current coupon (essentially the MBS yield lenders use to derive par mortgage rates after servicing and guarantee fees) was 4.381%. The 10 year Treasury note yield was 3.693%.
Yield Spread Calculation: 4.381% - 3.693% = 68.8 basis points
When the Federal Reserve does exit the agency MBS market, our inner circle estimates the secondary market current coupon yield spread will widen to 100 basis points over benchmark yields.
If the 10 year Treasury note touches 4.00% and the current coupon yield spread widens to 100 basis points, the MBS yield lenders would use to derive the par mortgage rate would be 5.00%.
This is the base yield used to determine mortgage rates. If 10 year Treasury yields do touch 4.00% in the months ahead, we expect the average par 30 year fixed mortgage rate to approach 5.50%
Adam Quinones is Managing Editor of Mortgage News Daily and co-Founder of the MBS War Room. Matt Graham is the creator of the MBS War Room, a first of its kind service bringing institutional quality market data and analysis to mortgage market professionals.



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