The Reckoning
Last month Freddie Mac issued a statement telling us how they would use their unlimited lines of capital. They would purchase out of their MBS pools ALL loans that were greater than 120 days late. This news caused a lot of concern in the markets, bids on long paper dropped like a rock, and everyone held their breath and waited for the speeds to come out. This morning they came out.
Most of the community banks that we call on don’t hold the type of paper that is most affected. 30 year paper, Interest Only paper, and Hybrid ARMs issued around 2007 would be the most at risk of experiencing high prepays.
Freddie decided that they would take the hit all at once…they would clear the logjam of late loans all in one month and then get back to business as usual. Fannie decided that they would spread the pain over several months so those pools will see a lower spike…but it will last longer.
So…the numbers. In aggregate Freddie 30 year bonds saw the following speeds this month:
5.50% coupons – 49.0% CPR
6.00% coupons – 67.2% CPR
6.50% coupons – 78.3% CPR
7.00% coupons – 83.6% CPR
2007 apparently had the loosest underwriting standards as measured by delinquencies…the 2007 pools fared as follows:
5.00% coupons – 52.8% CPR
5.50% coupons – 61.9% CPR
6.00% coupons – 74.8% CPR
6.50% coupons – 89.7% CPR
7.00% coupons – 97.9% CPR
Interest only paper was also expected to fare poorly in this evolution and it did exactly that. Freddie interest only paper saw these speeds:
30 year I/O 6.50% coupons – 92% CPR
40 year I/O 6.00% coupons – 95% CPR
40 year I/O 6.50% coupons – 97% CPR
It is important to keep in mind that these are one month speeds and that they are not expected to continue at this level. This was the clearing of the logjam so to speak. The plan at Freddie Mac is to be much more diligent in keeping these pools clear of late loans. This shouldn’t be a problem as new accounting rules favor purchasing late loans out of the pools AND they have unlimited lines of capital from the US Government.
How can you see if you’re affected?
Lucky for you…you’re friendly neighborhood fixed income firm (ahem…Vining Sparks…ahem) already has the framework in place for you to track your portfolio performance online. If we have a copy of your investment portfolio you can log on to the website and go to the “My Portfolio” section to see the speeds for all of your pools.
If you need some help with the website, need a password, or need to get your portfolio loaded so that you can use these features…just let me know. It’s a piece of cake to get it all going.
The strategy that got killed by reality
The interesting thing about this cycle is that in some corners of the investment world it spawned the idea that prepays wouldn’t be a risk factor this time around. The idea was that because nobody could qualify for a refi that we wouldn’t see high prepays and therefore…huge premiums are a safe play.
We disagreed with this idea from the outset. We could not get comfortable with the “buy the biggest premium that you can find” strategy. Our view was that the risk of loading the boat with high premium paper far outweighed the potential benefits. We had some heated debates even with our own trading desk about this…and this morning we get to call them and say “I told you so.” Normally we wouldn’t be so juvenile as to actually call and tell them that but they started it by calling us crazy for not seeing the value in huge premiums so we feel it’s our obligation to make the call.
It reminds me of a conversation I had with my 6-year old daughter as I was dropping the kids off at school last week. I’m in the carpool line and someone up front blocks the bus entrance with their vehicle and turns the normally smooth system into complete gridlock. I’m working on my first cup of coffee, and I’m generally not a “morning person” to begin with, and I’m watching this like it’s a bad movie on TV and before I know it I’m muttering “look at this dummy…messing up traffic because they’re blocking the entrance.”
At that point my 6 year old leans forward, surveys the situation and she says “Yeah Dad…you know not to do that, and you’re not a genius.” And just like that I was dragged back to reality…humbler than I was just 10 seconds earlier.
If a non-genius like me could see the problems on the horizon with huge premiums I don’t know how the really smart folks could miss it. Maybe more investment houses need to have 1st graders on staff for a reality check every now and again.
Oh yeah…the Unemployment Rate was released
In my mind the prepay story is the news of the day BUT…the Unemployment Rate also came out and it is a hugely important number so we need to look at it too. Before we start a discussion on the Unemployment Rate it’s important to point out that there is a tremendous amount of “noise” surrounding this number right now.
You’ve got hugely disruptive weather patterns across much of the country cited as a factor that could push the rate higher. You also have about a million people being hired to help run the census which should offset some of the negative factors temporarily. Complicating things further is that you have the normal ebb and flow of workers losing their jobs, finding new jobs, and perhaps the toughest factor to quantify…some number of workers even leaving the workforce.
So…what did the Unemployment Rate do? Nothing. It remained at 9.7%...the Bloomberg Survey estimate was 9.8%.
Elsewhere in the economic news…
Change in Non-Farm Payrolls was -36k jobs vs. an estimate of -68k jobs.
Change in Manufacturing Payrolls was an addition of 1 thousand jobs vs. a -15k estimate
Avg. hourly earnings Year-over-Year for All Employees 1.9% growth vs. a 2.00% growth estimate
So overall today’s data paints a picture of an economy that still has a very high unemployment rate, is losing jobs at a slower rate than expected, and whose workers aren’t earning as much income as the survey anticipated. The data do not point to a robust recovery, nor to inflation, and this tends to validate the Feds view that they won’t be raising rates anytime soon.
The market is pulling back across the length of the curve. The 10-yr Treasury is off just over half a point to trade at 3.68%.
If you have any questions or if there is anything I can be doing for you just let me know.
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