Annaly Capital Management Releases Monthly Commentary for January; Providing Comments on Houing Finance
Washington Watch
The next voice to be heard in the debate on the future of housing finance in
The core of the debate over housing finance reform is the government’s role in the mortgage market. Right now, that role is significant, largely through the credit guarantee that is wrapped around Agency MBS. Fannie Mae and Freddie Mac, of course, are the most prolific providers of this guarantee (although
But is government involvement necessary for the housing finance system in
To argue, however that the US mortgage market doesn’t need government involvement because other countries without a Fannie/Freddie/Ginnie model have similar home-ownership rates and manageable mortgage costs misses some very significant points. First, the mortgage capital stack in the US is unique. Whereas securitization is the largest capital formation tool in housing credit in the US, in
Second, the government guarantee is such a powerful advantage for US homeowners looking to buy or refinance a primary residence. The current housing finance system, certainly the one that prevailed until underwriting standards started to slip around 2004, is the most efficient credit delivery system in the world. Securitization allows borrowers of similar creditworthiness using similar mortgage products to receive the benefits of scale in pricing, and the government guarantee to make timely payments of interest and principal scales the process even further. The to-be-announced market is the window through which much of this scale occurs; it levels the playing field for smaller loan originators and community banks and enables lenders to offer longer rate-locks for borrowers. It is what makes possible the very popular 30-year fixed-rate mortgage with a down payment that is manageable for a wide swath of creditworthy borrowers (20%, with or without primary mortgage insurance for a conforming borrower), but also maintains other underwriting standards as well.
Third, and we say this only half in jest, anyone who suggests that a money-center bank, European or otherwise, is not a government-sponsored enterprise hasn’t been reading the papers lately.
Aside from all this, and perhaps most importantly, the price and availability of credit and the value of our housing stock matter a great deal to current and prospective homeowners, the vast majority of whom pay their mortgages on time, take pride in their homes, form the basis of solid communities in America and have already seen their home values fall 25% or more. If one were to ask them to chime in on this issue, our guess is they would want to maintain the best aspects of the current system.
The message from the bond market is loud and clear: We are prepared to fund our neighbors’ homes, in size and at relatively attractive rates, particularly if there is a government wrap involved. Yes, protect the taxpayers by guaranteeing only soundly underwritten mortgages and charging appropriate guarantee fees, and allow for a vibrant and competitive private-label market by carefully defining the conforming box, implementing sensible risk retention rules and setting risk-priced guarantee fees. If policymakers, however, resolve to have no government involvement at all, the bond market will price it out for you, but the likely outcome is a residential mortgage market that is smaller, more expensive, and less liquid.
The Economy
In last month’s commentary, we asked readers to submit fresh alternatives for “choppy” or “uneven” to describe the economy. The winning submission, bimarian, means “of or related to two seas.” (Thank you, RAM!) In the first part of the year, as the Federal Reserve’s initial foray into quantitative easing came to a close, fresh signs of economic stagnation began to emerge. Initial jobless claims stopped their decline and began to rise through the summer. GDP growth slowed from 5% at the end of 2009 to just 1.7% in the middle of 2010. Nonfarm payroll growth peaked early in the year and then declined to disappointing, though still positive levels. The unemployment rate remained stubbornly above 9.5%. Equity markets peaked around the time that the Fed was winding down its first round of quantitative easing (QE1) and subsequently suffered a correction of about 15%. During the same time period, the 10-year Treasury yield peaked out near 4% before making its way below 2.5%.
The Fed’s Jackson Hole summit at the end of August marked the sea change. Chairman Bernanke’s speech soothed markets by hinting at another round of quantitative easing (QE2), but what really got things going was his
The question before the house is the sustainability of the recent growth trends. Where will the next dollar of GDP growth come from? The great hope in 2011 is that corporations are going to take over the spending yoke from the government. As the graph in our online version shows, as of
In 2011, we expect the tug-of-war between sectors that have the willingness and ability to expand their debt and invest their cash like the federal government and corporate credits (see below) and those that don’t, like municipal borrowers, financial companies and households, to continue in bimarian fashion.
The Residential Mortgage Market
Prepayment speeds in December (January release) for 30-year Fannie Mae MBS slowed 5% from the prior month, in line with dealer expectations. Fannie Mae reported a drop of 4.4% in Constant Prepayment Rate (CPR) to 25.8 CPR. Lower coupons fell the most, with speeds on 30-year 4s and 4.5s down 10% to 10.1% and 22.9 CPR respectively. Similarly, aggregate speeds on Freddie Mac 30-year MBS declined 6.5% to 29 CPR. Looking ahead, speeds are likely to continue to decline on the implementation of increased Fannie/Freddie guarantee fees, seasonality and the recent backup in Treasury rates.
Measured by the spread between the yield on the current coupon mortgage and the yield on the 10-year Treasury, 2010 was a relatively stable year for Agency MBS. The year ended with a spread of 83 bps, only 12 bps higher from where it began the year, with a wide of 99 bps (
According to Barclays Capital’s Outlook 2011, the market expects continued muted prepayment behavior in 2011 “due to diminished borrower responsiveness to rates, incrementally tighter underwriting and persistent origination capacity issues.” The graph in our online version puts 2010 prepayment behavior in historical perspective. Despite a 130 bps rate incentive for refinancing in the mortgage universe, the aggregate prepayment speed during 2009 and 2010 was only 25 CPR, or roughly a third of the historical norm at similar levels of rate incentive in the prior decade. Clearly the current mortgage stack is demonstrating signs of substantial “burn-out,” or unresponsiveness to rates. Burn-out, coupled with tighter underwriting standards, is a likely recipe for relatively tame prepayment speeds in 2011, all other things being equal.
The Commercial Mortgage Market
“Alive! It’s alive!”
Commercial mortgage-backed securities (CMBS) issuance for 2010 came to approximately
With such momentum in mind, industry veterans are forecasting 2011 CMBS issuance to total anywhere from
Structurally, there were some improvements to 2010 CMBS transactions. Credit enhancement went back to 2002 and 2003 levels of 18% to the AAA class, a welcome relief from the aggressive levels for 2006 and 2008 vintages. We anticipate some pressure to subordination levels in 2011 as originators compete for product.
We estimate that approximately
The Corporate Credit Market
The corporate credit markets have started 2011 with excellent follow-through momentum from a stellar 2010. Fundamentally, the sector continues to benefit from micro-oriented themes of balance sheet deleveraging, liquidity management, declining default rates and minimal corporate risk taking. Last month, an additional positive catalyst came in the form of a macro surprise: the wholesale extension of the Bush tax cuts. Current valuations present a double-edged sword for credit investors. While higher valuations are a manifestation of “good times,” they also imply that 2011 will be a more challenging year than its predecessor.
The Fed’s effort to inflate financial asset prices was broadly successful last year. The table available in our online version shows the degree that risk taking was rewarded across the investment spectrum. Even the rates sector, the worst performer, beat cash by several hundred basis points. In high grade corporates, the unexpected drop in Treasury rates together with tighter spreads pushed returns towards the double-digit threshold. Relative to other high quality fixed income segments, the sector benefited from its high interest rate sensitivity (duration is 25% higher than the broad index). In high yield, the investor preference for BB credit risk played out in returns as it outperformed single-Bs. Leveraged loans underperformed their high yield counterparts due to their lack of rate duration. Further down the capital structure, equity finally beat its fixed income counterparts on the return front, despite resilient flow trends in favor of bonds.
From a yield perspective, bonds are less competitive with equities than a year ago. Consider that the forward earnings yield of the
From a fundamental perspective, the corporate credit cycle is playing out more normally than other cycles. It is not overwhelmed by secular forces nor is it still plagued by post-bubble chronic retrenchment. Most recently, the credit profiles of firms in deep cyclical sectors like autos, specialty retail, and gaming have turned and are widely expected to have positive credit rating momentum going forward. Likewise, the leading indicators of defaults— distressed price ratios, easing of lending conditions, negative real short-term rates — are underpinning 2011 consensus forecasts for corporate defaults in the 2% range. So in the words of baseball great Yogi Berra, 2011 “is déjà vu all over again”: With corporate balance sheets in improved condition, the risk to credit performance would have to come from large-scale macro factors—like changing interest rates, sovereign woes (both here and in
The Treasury/Rates Market
Treasurys had a very poor month in December, after a similarly woeful November. The intermediate part of the curve was the underperformer as 5-year, 7-year, and 10-year Treasurys all sold off roughly 50 bps, while the 2-year only sold off 11 bps and the 30-year sold off 23 bps. The initial catalyst for the sell-off was a general sense of increased optimism due to improving economic data, but the sentiment accelerated with the tax compromise from Washington—which raised concerns over a deteriorating fiscal picture, a stronger near-term growth outlook and a sidelined Fed. The sharp pace of the sell-off made it clear that many investors were caught offsides after the QE2 decision by the Fed combined with typical year-end forces (balance sheet reduction and closing the books on 2010). Another factor in the price action was the pace of flows out of bond funds, both actual and prospective: while many of the flows to-date have been from municipal bond funds, the market is alert to the possibility that retail investors will see their poor end-of-year returns in bond funds and sell in order to chase strong equity returns.
December saw
The macro landscape today is looking quite a bit like that of a year ago, with accommodative monetary and fiscal policies and a resulting upturn in economic prospects, as well as questions regarding sustainability, from both a fiscal and a long term growth trajectory standpoint. In this environment, market participants put current relative and absolute yields in context in order to guide their future expectations, for example the differences between different futures contracts, forwards rates versus spot rates, and yields at different points on the yield curve. In the graph in our online version, we see that the spread between the yield on the 2-year Treasury and the 10-year Treasury, a measure of the steepness of the yield curve, is about as wide (or steep) as it was a year ago, while the 2-year yield is lower. The question gets begged: Will the Treasury curve steepen or flatten? And from which end? Stay tuned….
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