Happy Days Are Here Again for MBS...Or Are They?
August 30, 1999
With 1999 touted as a record year for housing turnover, a general consensus in the market that the Federal Reserve will not touch interest rates for the rest of the year, and decent technicals for mortgage-backed securities, mortgage players seemed upbeat last week.
"Mortgages are doing well, the Fed announcement was expected, and nothing out of the ordinary shook the market," commented one MBS trader. "Extension risk should not be a major worry, the prepayments are going to continue to be fast, though a bit slower than the summer.
"And in the not-too-distant future mortgages will pass the Treasury market in size."
For the past two weeks, both residential and commercial mortgage-backed securities have outperformed Treasurys.
Spreads on the current coupon Fannie Mae had gotten as wide as 106 basis points over past weeks, which represents the widest spread the market has seen since December 1989.
Since then, spreads have narrowed back, hitting an option-adjusted spread of 99 basis points over late last week, approximately a seven-point correction. For the 10-year CMBS bond, the spread had widened to 159 basis points two weeks ago, and it was at 148 basis points towards the end of the week - which is an 11-basis-point narrowing.
Additionally, market players report that the technical underpinnings to the mortgage market have greatly improved: Issuance of agency pass-throughs has fallen by $3 billion from the issuance in July.
"We expect to see dramatic further declines from September through the end of the year," said one MBS expert. "We think we'll be at about $25 billion monthly issuance pace in December relative to $49 billion in July. This is a very material turnaround."
While mortgages generally fell in line with Treasurys last week, swaps seemed to remain unchanged, though the roll in 7.5% and 8% coupons looked attractive.
"There is a general expectation of a declining in spreads with the decline in volatility," said David Montano, a director of mortgage research at Credit Suisse First Boston. "The decline in volatility is helping mortgages outperform other spread product."
Further, Montano mentions that there will be a higher level of securitization than in the past. For 30-year Fannie Mae bonds, August showed a supply of $15.5 billion, for September there is an expected $14 billion, and there should be approximately $12 billion in residential MBS for October, Montano added.
"But coupon production, which had been mostly 6.5's and 7's, is expected to switch to predominately 7.5% coupons in October," he added.
Mortgage market insiders also spoke quite a bit about a debate over 8% coupons. Though it is mostly a technical issue for traders, it seems that most of the production of 8's are from 1997 or earlier, and some companies believe that an upcoming new production of 8's - which had been spurred on by the backup in rates in July and August - is worth more than the older variety.
According to one participant, if somebody buys an 8 pass-through, it is more likely to be from either 1996 or 1997. However, there is expected to be more issuance of new 8's in October, because there is a two-month lag between the obtained mortgage rate and when the mortgages get securitized.
This topic, which seems to have been on the minds of several traders, is significant because going up in coupon has been difficult in the past because of a lack of a supply in the market. But with the advent of these new higher coupons, MBS trading may be impacted.
"With more buying, we will be increasing the size of the mortgage universe, compared to the Treasury universe," added Montano. "If durations of mortgages are longer, then mortgage hedgers drive the market.