FRM Update

December 3, 2018

During the past trading week, yield spreads on current production coupons to Treasuries reversed their recent course and tightened 5 to 6 bps from the previous week.  The risk-on tone in the broader market this morning is continuing to cause modest downward pressure on yield spreads.

However, the basis widening trend that has been solidly in place for most of 2018 has resulted in more appealing spread levels. To put this year’s volatility into perspective, yield spreads have exhibited the sharpest intra-year move since the taper tantrum of 2013.  Spreads are back to levels last observed during 2013 for the 30-year sector and early 2017 for the 15-year sector.

The overall theme in the MBS market continues to be more attractive valuations and higher yields. Premium adverse investors can now take advantage of most of the sector regardless of coupon, as a significant portion of the space is currently trading at a discount. Financial institutions have been targeting short duration pools with lower coupons in recent months, but during the past few weeks we’ve seen institutions begin to selectively add more duration to their balance sheets.

We’ve also seen an acceleration of two-way flow (investors selling and buying).  The selling has been spurred on by investors preparing their balance sheets for year-end and positioning their portfolios for improved performance.  Given that some institutions are ahead of their 2018 budget and the fact many portfolios contain securities with book yields below current market yields, attention has shifted to portfolio restructure transactions that have the potential to boost 2019 income.  The general thought is to sell lower yielding securities at a loss and use proceeds to purchase higher yielding instruments that will provide improved levels of interest income in future periods.

The following represents a summary of the activity in recent weeks:

• 10-Year – There continues to be strong bank demand in this sector because of the defensive nature of these structures, which offer significant near-term cash flow.
• 15-Year – This remains the most active sector within the MBS space for financial institutions. As previously mentioned, investors have been active in lower coupons trading at a discount (2.0’s to 3.0’s).  Seasoned 15-year pools, which for much of the year traded in the low-mid 30s on an I-spread basis, have widened out around 8-10 bps since the beginning  of October. The pay up over TBA for pools with seasoning between 18 to 36 months remains reasonable.  And in some cases, investors can potentially receive less price volatility and greater stability of cash flows relative to new pools, for a modest trade-off in projected yield.  Please see a recent Strategic Insight discussing the current merits of slightly seasoned, below par 15-year MBS.
  • There has also been steady demand for higher coupons (3.5’s and 4.0’s) with investors seeking slightly higher yields.
  • Finally, TBA pricing for 15-year 3.0’s between FNMA and FHLMC product remains wide versus historical levels.  FHLMC normally trades behind FNMA by 1 to 2-ticks because of liquidity differences.  Currently, we are seeing FNMA trade 7 ticks in front of FHLMC.
• 20-Year – Yield buyers have also focused on new production 20-year 3.5’s trading just under par.
• 30-Year – This sector was very active last week with buyers adding both seasoned and new production pools. The new production pools consisted mainly of FNMA 4.0’s trading just over par, while the seasoned product was concentrated in high LTV FNMA 3.0’s. The potential for higher turnover in an increasing home price or a decreasing home price environment has attracted buyers to this sector.  Prepays of high LTV collateral are likely to be steeper than those of lower LTV collateral.  A portion of this collateral is represented by borrowers that used the HARP refinance program.  As home prices have appreciated, the current LTVs for higher LTV collateral have migrated lower.  As a result, the borrowers are incentivized to refinance much faster than the low LTV collateral because of the payment savings resulting from lower MI payments (more than rate incentive alone).  Alternatively, when home prices decline these borrowers would become eligible for the streamline HARP program replacement, which would lower the costs of refinancing because it will require no appraisal and little to no credit underwriting.  In other words, the high LTV collateral is likely to exhibit higher turnover compared to low LTV as long as home prices appreciate or depreciate.
• FNMA DUS and Freddie K’s – Agency CMBS has been the fastest growing sector in bank portfolios for the past several years. The focus during the past two weeks for FNMA DUS was on 7- to 11-year finals.
  • Yield spreads on Freddie K’s have widened sharply over the past two months and investors are targeting 3- to 5-year finals.  There has also been steady demand for floating rate structures (FNMA Aces and Freddie K’s in which the fixed-rate cash flow has been swapped out for floating-rate cash flow).
• MBS pools – The MBS desk routinely creates custom MBS pools to assist financial institutions with the Community Reinvestment Act requirements.

Mortgage Rates and Refinance Activity

• Benchmark mortgage rates declined 4 to 8bps last week (11/30).
  • 15-year mortgage rates decreased 4bps to 3.96%, which is 16bps above the YTD average of 3.80%.
  • 30-year mortgage rates increased 8bps to 4.68%, which is 26bps above the YTD average of 4.42%.
  • 15-year mortgage rates have increased 76bps in 2018, while 30-year mortgage rates are up 83bps YTD.

Housing:

Mortgage Applications: Mortgage applications for the week ending November 23 rose 5.5% on an 8.8% increase in purchase apps and a 0.5% increase in refi apps.  Applications remain very low despite the positive results for the week.

New Home Sales Slump to Slowest Sales Pace Since March 2016: New home sales sank unexpectedly in October as struggles for housing activity continued to show few signs of abating. While the 8.9% monthly drop exaggerated the relative severity a bit, considering a large positive revision to September’s sales from -5.5% to +1.0%, the annualized pace of 544k units was the weakest since March 2016 . No regions were spared, as all four posted notable declines. The sharpest drops occurred in the Northeast (-18.5%) and Midwest (-22.1%), which combined only account for 15% of total sales. However, sales in the South, the largest-volume region, declined 7.7% to their lowest since July 2017 and the West saw 3.2% fewer contracts signed, the least since August 2017. Higher mortgage rates have further crimped affordability that has suffered as price gains have consistently run faster than wage growth. But slower sales have helped pushed the median price down 3.1% from a year ago to $309.7k, the lowest since February 2017. Too little supply was a long-time culprit for rapid price gains, but a shortage no longer seems to be the issue. The number of new homes for sale jumped to its highest level since January 2009. The months’ supply on hand has surged from 5.3 in March to 7.4 in October, the most since 2011. While new home sales tend to see significant revisions, shown to be true in Wednesday’s report, October’s disappointment will for now serve as another sign of continued slowing in the U.S. housing market.

Pending Home Sales: Pending home sales fell unexpectedly in October in the latest disappointing housing report. Pending sales dropped 2.6% in October, the most since January and the second biggest monthly decline since 2013. The persistent weakness over the last couple of years has now pushed pending sales to their weakest level since the summer of 2014. The three largest regions posted fewer pending contracts with the biggest slowdown seen in the West. After spiking 4.5% in the prior report, October’s 8.9% plunge was the sharpest in the West region since 2010. Pending sales in the South, the largest-volume region slid 1.1%, a fourth consecutive contraction, while activity in the Midwest dropped 1.8%.

Michael S. Erhardt, CPA

Senior Vice President, Investment Strategies

Vining Sparks IBG, LP