Market Update 8 25 11 _ The Refi-Boomerang

The good ol’ days

Do you remember the go-go days in the first half of this decade?  It was a rare day that you checked the mailbox and didn’t see an offer from someone telling you to refinance your house.  It was so easy a caveman could do it.  It worked all the way up to the point where the wheels came off the bus.  The dual bubbles of housing and credit popped and it all grinded to a halt.

Borrowers lost their jobs, they struggled to repay loans, home prices plummeted, LTV’s were out of whack…we all remember the story.  When the dust settled we were left with a landscape of shattered dreams.  A lot of people dusted themselves off only to find that they owed a lot more on their home than it was now worth.  Many others lost their jobs at the same time.  Refinance opportunities dried up as credit scores and home values fell in tandem. 

In that environment many people pushed the idea of buying high premium MBS because the risk of refinance-driven prepay activity was gone.  We were not among that group…we bought discounts as long as we could.  After all…the definition of “Risk” is that more things can happen than will happen.  Why expose ourselves un-necessarily?

That was fine while it lasted but as rates dropped further it became almost impossible NOT to buy MBS at a premium…there were no coupons low enough to provide discount prices.  Now even those investors who tried to avoid high premiums are forced to operate in a world that is filled with them.

It’s like a Boomerang

The refi story is like a boomerang…every time you think it’s going away it turns around and comes back…and you’d better be ready to duck.

This refi-boomerang story brings to mind one of what I suppose could be called “foundational phrases”.   These are bits of wisdom that I’ve gleaned from people in my life over time.  These nuggets are usually encapsulated in a catchy phrase that makes it easy for people like me to remember and digest.  One example is from Major Lissner, USMC, who used to throw this phrase out a lot in times of pain and difficulty; “do you think anyone gives a “bleep” that you’re miserable?”  I loved the phrase for its Spartan simplicity.  It said “I care” and “I don’t care” all at the same time…it was brilliant. 

But that’s not the phrase that comes to mind with regard to the mortgage refinance issue.  The phrase I’m thinking of today is by coincidence from another Marine Corps officer who used to caution us that “If you run your butt up a flagpole it’s gonna get shot off”.   It’s a bit of wisdom that at its most basic level addresses a topic near and dear to us…risk management.  Years after I first heard the phrase I got to see the practical application.  I was watching the news one night and they were covering one of the many riots in the Middle East when I actually saw a guy shimmy up a flagpole.  Guess what he got…yep…shot.  At that point I understood that this was a generally accepted principle and that I could rely on its wisdom going forward.    So with that in mind I reflect on our current predicament…which is one of exposure…and how to not get our hind-end shot off.

Standby for impact

We’ve frequently discussed the impact that a wave of mortgage refinancing would have upon the economy.  From our viewpoint the first effect would be that investors who purchased MBS at large premiums would be burned, secondly investors who purchased MBS at lower levels and rode them to gains would see those profits erode, and lastly it would put huge amounts of money into the pockets of homeowners which they could use to stimulate the economy.  There are many other effects that would ripple through other areas but those are beyond the scope of today’s article.

The first two issues on the list above (those that affect investors) are likely to be considered collateral damage…few people outside of our industry will care that your yield burned down or that your bond accounting gains have disappeared.  You will be viewed as greedy investors, and as Major Lissner used to ask “do you think anyone gives a “bleep” that you’re miserable?” 

It’s the last item on that list that is the really shiny and attractive prize in this deal: money in the pockets of homeowners/consumers/voters.

Can they do it?

From the governments standpoint this has to appear to be an almost magical solution.  By pushing and pulling on the levers of power they might be able to create a landscape where many of the hurdles to refinance are removed.  This would allow a lot of capital to roll right into the pockets of spenders.  This would in theory help to bring back the good ol’ days where everyone spent, everyone had a job, and there were no problems too big to borrow our way out of.  All of this just a year before the election, what’s not to love?

A few things are clear.  One is that the programs put in place thus far to “help” homeowners haven’t been nearly as successful as their creators had hoped.  Next is that there is no shortage of people who would love to refi but can’t.  Another is that rates are low enough to pull it off…you just need to bully the rest of the pieces into place.  Lastly the incentive is there…people in Washington are getting desperate for some positive momentum in the economic data.  Estimates of how much discretionary income would be created by pulling this off run well into the tens of billions of dollars per year.

One big piece of this puzzle is already in place…the Fed has driven rates to historic lows.  Obviously this is not the only piece of the puzzle…many people can’t refinance because they owe more than the home is worth.  Others are prohibited because they have a habit of paying people late, less than what they owe, or simply not paying them back at all.  There are still hurdles that need to be cleared for this refi wave to take shape…but some of the important pieces of the foundation are there.  The longer rates stay low the longer the government has to come up with a way to make this work.  This is a concern that is stalking the markets currently. 

What can you do?

In what has become an almost annual evolution in the investment world we are reviewing MBS holdings to determine which bonds are most at risk for negative yields based on refinance-driven prepay activity.   We have created analytics that will identify bonds that hold the potential for negative yields based on your book price along with Bloomberg projected speeds and the actual speeds being posted by each bond. 

This report can help you identify bonds that you might not be comfortable holding.  The report can also provide some peace-of-mind if you discover that your portfolio doesn’t have the potential to deliver negative yields.

We run this report on a complimentary basis.  If you would like us to run your portfolio just send me your latest bond accounting report and we’ll get it done.  For those of you that are already on our bond accounting system just shoot me an e-mail and I’ll pull the data and get it done. 

If you have any questions on this material or if there is anything I can be doing for you just let me know.  Until then…don’t run your hind-end up a flagpole.

Steve Scaramastro, SVP

800-311-0707

 

 

 

Market Update 8 17 11 _ Stampede

Stampede

Hey everybody…Europe is back in the headlines!  I never thought I’d say it…but I miss the days when all of the news out of Europe was about the royal wedding.  As new concerns arise over sovereign debt in Europe we have yet another flight to quality.  The 10-year Treasury is up over a point to trade at a 2.03% and the Down Jones (yeah…I know how I spelled that) is off 350 points to trade at 11,063.

Other news this morning was that Initial Jobless Claims posted 408,000 new claims vs. an expectation of 400,000.  CPI was a bit higher than expected but that is being discounted completely amid this stampede to safety.

Even the records are setting records

The 5-year Treasury set another record low today of 86 basis points…but before I could type that it went down again and hit another new record low of 83 basis points…I’d better quit typing.

Gold hit another record high and oil is down to $83 a barrel.  This is the markets way of preparing for a global slowdown. 

From the “interesting timing” section

Two weeks after S&P downgraded US debt, news is hitting the headlines that the US Justice Department announced that they are investigating S&P.  I have a friend at a bank in Florida who asked me right after the downgrade “what do you think S&P will look like a year from now?”  At the time I didn’t understand the question…now I do.  Payback can be rough. 

Surprise at the end

As I wrap this up I just got the Philly Fed index release.  This index tracks manufacturing trends in the Philadelphia Federal Reserve district.  A positive number indicates expansion in manufacturing, a negative release indicates contraction.  The expectation was for a positive 2.0 level which would indicate a very modest expansion.  The actual release that got posted this morning was a negative 30.7.  I don’t know that words can adequately express the magnitude of the index missing the mark by that much.  Sound effects might be more descriptive.  When that number was released I pointed it out to the rest of my office and the collective gasping/groaning that commenced made it sound like everyone in the office had been punched in the stomach at the same time. 

The market, which was already it full-bore rally mode, drove prices even higher and pushed the 10-year yield down to a 1.99%...which may also be a new record…but I’ll have to research that.

The Dow is now off 500 points to trade at 10,900.  Just when I was hoping that this would be a less volatile week the captain turns on the seat-belt sign and asks us to not move around the cabin…the turbulence looks likely to continue. 

If you have any questions or if there is anything I can be doing for you just let me know.

Market Update 8 10 11 _ The Morning After

 

The Treasury market continues to move lower today.  The 10-year Treasury is up over a point to trade at a 2.12% currently and the Dow Jones has given back all of  yesterday’s gain…it is off 434 points right now. 

 

Where to start?

 

One of the first things to be aware of as we settle in to our new operating environment is that there will be a large spike in the volume of called bonds.   In a phone call with FHLB this morning our traders were told that recent called bond volumes over the past few months were around $60 billion but that number is expected to jump up to $90 billion very shortly. 

 

Given the drop in rates and the increase in the number of bonds that are now “in the money” to be called I wanted to highlight a report that we have available to you.  We have a Predicted Call Report that we run to show customers the dates on which bonds they hold are likely to be called based on the current yield curve.  This has historically been a very accurate and very helpful report for those who manage fixed income portfolios.  This is a very good way to get a handle on the amount and timing of cash flows that will be coming out of your portfolio in the form of called bonds.  If you would like to receive this report just shoot me your most recent bond accounting data and I’ll run the analytics for you.

 

Now is a great time to review the structure of your investment portfolio and make sure it’s aligned with your Asset/Liability needs, expectations for interest rates, and cash flow requirements. 

 

The commitment

 

Yesterday afternoon was a whirlwind.  It’s difficult to describe the energy level that existed in the aftermath of the FOMC statement.  Now that things are slowing down a bit we can start to really look at what this means.  One of the first things to consider is that the Fed just pledged to keep the overnight rate low for at least the next two years.  Can they do it? 

 

Keep in mind that the reason the Fed made this pledge is because the economy is transitioning more toward another recession than toward expansion.  Given the macro-economic background the Fed not only looks to have the ability to keep rates low for a long time, but it looks like they will have a lot of company on the Treasury curve that will help keep rates low along the length of the curve.  Now if you throw the European problems into the mix you have even more pressure on Treasury prices which will force yields lower still.  Certainly the Fed can’t keep rates low by themselves…but the global economic picture looks like it will be their partner in keeping rates low for quite a while.

 

What if they need to tighten?

 

Can they just go back on their pledge to hold rates low through at least mid-2013?  If the macro-economic picture suddenly gets rosy and the Fed feels the need to remove some of the accommodative policy they can certainly do so…and they can do it while staying true to their mid-2013 pledge.

 

The astute reader might recall that in a Market Update piece a few weeks ago I asked you to print out a list and tape it to your wall...in case you didn’t tape to the wall I’ve included it again below.  This is the framework the Fed had outlined for tightening monetary policy when the appropriate time comes.  You’ll notice that the step labeled “Raise the Fed Funds Target Rate” is pretty far down the list. 

 

 

1 – They will stop reinvesting their portfolio cash flows

 

2 – At the same time (or shortly after) they will change the guidance in the FOMC statement

 

3 – Initiate temporary reserve draining operations

 

4 – Raise the Fed Funds target rate

 

5 – Sometime after they’ve begun raising rates they will begin outright sales from the portfolio

 

Now there weren’t many people who expected to hear the Fed put a hard timeline of “at least two years” on the prospect of rates going up…but in the event that the economy gets heated up prior to mid-2013 you can see that they have three actions they can take to take that will tighten policy without raising the overnight rate.  I don’t want you to hold your breath waiting for this to happen…I just wanted to point out that nothing is written in stone.  They Fed acknowledged yesterday that the recovery is in real trouble, and they are likely to be accommodative for a long time.  Unless the rest of the world disagrees with this perspective, and/or European sovereign issues suddenly get better, one would expect longer rates to remain low as well.

 

Thoughts on investments

 

Below are a few talking points on the investment side…in no particular order. 

 

Callables

 

You will be getting a lot of cash back from your callable bonds.  Your callable bond portfolio just became a lot shorter than you thought it was going to be.  Many investors have spent the last three months trying to sell longer bonds they bought last October because they didn’t like the losses they had.  In a week’s time they have gone from looking at taking losses on those bonds to wanting to keep them and worrying that their big yields will go away.  The point here is that your callable portfolio just became a whole lot shorter than it was last week. 

 

There are a lot of longer maturity bonds out there that will effectively be 1 to 6 month pieces of paper.  If you know you have cash coming back on certain dates (ie you sent us your portfolio and we provided you with a very helpful Predicted Call Report) it might make a great deal of sense to buy replacement securities today rather than wait for the actual cash flow date to arrive and be forced to reinvest after the rest of the world has already pushed yields lower.

 

MBS

 

Traders are expecting a lot of prepay activity going forward in our new rate environment.  If you paid high premiums for MBS paper with 15 year or longer finals you might want to consider your exposure to prepays.  Bids are strong on MBS paper right now and there will be cases where it makes sense to unload and reposition into lower coupon paper.  Yes…reinvestment rates will be lower…but you also need to consider what is going to happen to the yield on your current MBS if they get hit with a prepay spike.  I’ve seen a lot of bonds in the last year or two who have negative yields once the prepay speeds hit 40 to 50 CPR.  While reinvestment yields may be low…they aren’t negative…its’ something to consider. 

 

WE HAVE A REPORT that will quickly show you which of your MBS are exposed to a prepay spike.  If you shoot me a copy of your bond accounting reports I can run this MBS report and help you identify the bonds that might make sense to sell.

 

SBA’s

 

The busiest desk this morning has been our SBA floating rate desk.  I’ve not yet received a lot of color yet but Full Faith and Credit floating rate product is in high demand. 

 

What to buy?

 

As always we need to consider our Asset/Liability, cash flow, yield, and policy constraints when making decisions.  Once those are met it will provide more direction…but in the absence of such direction we can make some general observations.

 

MBS premiums will remain exceptionally high.  Moving into lower coupons such as 15 year 2.50% paper begins to make sense. 

 

Fixed to Float structures should come back to the market as investors will begin to adjust to the 2-year time frame the Fed has outlined.  These can come in the form of Agency ARMs or straight corporate fixed to float paper.  Generally these structures can get you a fixed rate for 2 to 5 years that then begins to float over an index such as Libor, Fed Funds, or Prime.  Structures will vary but these will remain popular.

 

Agency bonds are a mainstay of bank investment portfolios and will remain so.  I would expect the main shift in this arena to be toward step-ups and longer final maturities as we settle in for a long wait at these levels.

 

Final thought

 

I think the new unit of measurement for the Dow Jones is 400 points.  Up or down 400 is no longer news worthy.

 

If you have any questions or if there is anything I can do for you just let me know.

 

Steve Scaramastro, SVP

800-311-0707

 

Market Update 8 8 11 _ The aftermath of the downgrade

Here’s a riddle for you: How do you get the price of the 10-year Treasury to jump up a point at the open?  It’s easy…you just cut the credit rating. 

This is gonna be huge

When I was a kid I remember hearing stories about the fabled M80 firecracker.  Legend held that these things could blow up toilets and mailboxes and nothing could cooler in the mind of a 9-year old than that.  We were all experts on the destructive force of the M80 despite the fact that none of us had ever actually seen one.  That all changed one day when we one of our friends went on vacation and came back with a whole bag of them.  Fate had smiled upon us.  We suddenly found ourselves in possession of a big plastic bag full of fire-engine-red M80 firecrackers with thick green and white fuses sticking out of them.  It was a bag of mayhem if such a thing ever existed. 

We couldn’t wait to start blowing things up…nothing was safe from our plotting…toilets, mailboxes, trees, dumpsters, cement trucks…nothing.  We held a power more awesome than any group of 9-year olds had ever held in history…and we were about to use it.  We figured the first one ought to be set off just by itself so we could witness the sheer power of it…to establish a baseline of sorts before we began the real experiments.

After a few seconds of trying to decide how far back we should stand, and who would light it, we got underway.  The fuse was lit, I was running for cover, everyone was plugging their ears in anticipation of the huge explosion that was coming…and…pop.  We got virtually nothing.  Something was wrong…our M80 didn’t really do anything.  We lit another one with almost as much anticipation as the first…and pop.  Same result.  No earth shaking explosion, no asphalt raining down on our heads…just a pop and the smoking cardboard wrapper of the M80 laying in the street.      

We were crushed.

It didn’t work like we expected  

The folks at S&P must be feeling the same type of disappointment this morning.  Late Friday afternoon they mustered up the courage to downgrade the long term credit rating of the USA.  They likely had a vision of borrowing rates sky-rocketing, politicians scrambling for cover, and creditors howling on TV demanding solutions…basically they had visions of exploding toilets and mailboxes.  

Rather than cause yields to move higher and politicians to beg forgiveness and come up with fiscally responsible solutions…borrowing levels are dropping as investors buy up all the freshly downgraded Treasury debt that they can.  Our trading desk relayed to us this morning that desks around the country have been given orders by large customers to buy all they can on the dips.  If prices drop, people want more. 

If you were holding your breath in anticipation of an M80 type explosion in the Treasury market you might want to relax a bit…early indications are that it’s going to be a pop…not a boom. 

The markets

There is a tremendous amount of liquidity in the market, there are still huge problems in Europe, and people still view the US debt market as the safest place to be…so we rally.  The 10-year is currently up over a point and a half and is trading at a 2.37%. 

Stocks are off across the board with US indices down anywhere from 1.5 to 2.5 percent at this point…and it will likely be a bad day…all day…for stocks.

Oil is off $2.66 a barrel to trade at $84.15. 

That’s the short story…I’ll keep you informed as things change.  If you have any questions or if there is anything I can be doing for you just let me know.

Steve Scaramastro, SVP

800-311-0770

 

 

 

Market Update 8 4 11 _ The Heat is On

For those who might be thinking about a quick summer vacation to Memphis, allow me to paint a picture for you.  I park my truck in the underground portion of our parking garage here at the office.  It is a dark and cool place that is well protected from the routine summer threats of tornados and hail.  Yesterday evening I left the office at 6:00 PM and when I turned the key in the ignition, my onboard thermometer read 105 degrees…and it was underground in solid shade all day.  If anyone in a cooler part of the country has a small office that's not being used I'd be happy to sublease it for the next few months.  I know, I know…what could be better than having a bond salesman right there in your own office, right?

Memphis isn't the only place experiencing the heat now-a-days.  The market is taking its share as well lately.  The headlines have been dominated recently by the high-drama and glamour of a political showdown over the debt ceiling and the future of our fiscal trajectory.   This is really good fodder for reporters because you can get lots of hype out of it without really having to understand much of what you're reporting on. 

Given the high profile nature of the debt story there has been an enormous amount of reporting on the topic…much to the detriment of some other newsworthy items that are being pushed to the back burner.  Two of the more significant recent events have been the downward revision of GDP and the declining manufacturing data that we reported on earlier.

Where is the Fed?

The Fed meets next week and I promise you that they are having some prolonged and heated discussions about those two numbers even as I type this.  It is now August 4^th.  Every time the Fed has addressed the state of the economy this year they have had to address the "soft patches" that have prevented us from achieving robust growth.  Each time they describe the negative factors as "transitory"…meaning that these events will be temporary in nature and don't pose a risk to sustained economic growth, and that they expect activity to pick up in the second half.  The longer they stick to this story the better the second half has to be to make up for the first...and given the recent economic data the second half doesn't look like it's gonna be a rock-star.

There has already been a growing choir of voices discussing the potential for QE3.  I'm not in that camp at this point.  If you read the Fed you know that the feelings about QE2 from the start were that it would have only a modest impact at best.  Given that QE2 was expensive and managed to underperform their already low expectations I think it will be difficult to find much support for another round of it. 

That's not to say they won't ever do it…there are a few within the Fed who have already mapped out a course that would lead them to vote for more Quantitaticve Easing…I just think that those members will have an uphill fight against the rest of the FOMC who don't want to throw good money after bad.  It's not hard to find FOMC members who have publicly stated recently that monetary policy can only do so much…at some point the Fed has to be done. 

The Market

Market reaction this week has been like a run-a-way train.  It's almost become a joke around here that the 10-year is up a point every 24 hours.  We are just a few short hours into the trading day and the 10-year is up 3/4's of a point to trade at a 2.52% yield, and the Dow is off 225 points to trade at 11,671. 

What does this mean to investors?  It's tempting to hold our breath and try to wait this rally out…hoping that we can put off some investment decisions until the market comes back.  However it could very well be that when the market finally reverses it could "snap back" to levels lower than where we are now. 

Roughly a week ago the 10-year Treasury traded at a 2.99% yield level…right now it sits at a 2.52%.  Watching the 10-year drop 47 basis points in a week is uncomfortable to say the least.  More worrisome is the fact that the drivers of this rally could push us far lower. 

Some reference points might be helpful here

The low point for the 10-year Treasury in 2010 was 2.38%.  The lowest GDP print we had in 2010 was 2.5%...our most recent print was 0.40%.

The low water mark on the 10-year for this business cycle was 2.04% in December of 2008.  GDP figures in 2008 ranged from 1.3% to -8.9%.  It's also important to note that in November of 2008 the NBER made the "official" declaration that we were in a recession, the markets were falling apart, and there was legitimate concern about a full-fledged depression.   If you really want to review the tone of the market from December of 2008 just go through your old inbox files and pull up the e-mail I sent you back on 12/19/08 titled "Bernanke is Fighting Depression and he's not using Zoloft".  I have it handy if you can't find it so just let me know if you'd like me to e-mail you a copy.

Why does this matter?

The most recent economic data are sliding toward recessionary levels.  They aren't there yet but if they keep mounting up in a recessionary fashion it's easy to believe we could see the 10-year trading somewhere between the "it's almost the end of the world level" of 2.04% from late 2008 and the "we think we're starting to recover" level of 2.38% from 2010. 

I just looked up to see the 10-year just went up over a full point in price on the day…it's now trading at a 2.47%.  The Dow is now off 354 points, and the 2-year Treasury just posted a record low of 27 bps.  Where she stops…nobody knows.  I have to wrap this up and go check on my truck to make sure it's not melting downstairs in the garage.

If you have any questions on this material, or if there is anything I can be doing for you just let me know.

Steve Scaramastro, SVP

800-311-0707