Market Update 4 9 09

Today’s market activity is being defined by Wells Fargo. Wells announced this morning that their Net Income was up around 50% on a year over year basis. They earned roughly $3 Billion in the first quarter. This was significantly more than the estimates and it has sparked a rally not only in Wells shares but in the financial sector as a whole. I can’t wait to see what the media does…criticize a bank for making money, or report the happy news that everyones 401k received a shot in the arm today…decisions decisions. The Dow Jones is up 200 at the moment putting it over the 8,000 mark early in the day. Treasury prices are off across the length of the curve pushing those yields higher. The 10-year Treasury is back on the north side of 2.90%.

Initial Jobless Claims continue to stay well above 600,000 per week. This morning’s release is the 10^th consecutive week that saw more than 600 thousand new applicants for jobless benefits. Since the first week of January we have see 8.6 Million people file for Initial Jobless Claims. Today’s report showed that 654,000 people filed last week.

Refinance?

There has been a lot of speculation surrounding mortgage refinance activity. To provide some perspective I’ve attached the latest print of the Bloomberg Refi Index. I took the timeline back to 2000 to show the history of the last cycle which made history with the speeds it produced. You’ll see that in 2002 the refi index hit 10,000 (the relative level here is important not the actual number 10,000). You’ll also notice that the index has been jumping up recently.

The current situation finds us with big gains in MBS securities, and many bonds that were purchased at premiums. As this refi index picks up you will see increased prepay speeds in your MBS portfolio. If you own a significant amount of MBS you’re already seeing the increased speeds. Increased speeds on bonds purchased at a premium will reduce your yield. An opportunity here is to sell MBS at a gain before the speeds pick up to the point that the yield burns down and the average life shortens dramatically.

There is no shortage of reasons to sell for gains at the moment. Some banks are using gains to pay for the FDIC special assessment, some banks are using the gains to improve earnings for the year, some banks are taking gains and adjusting portfolio allocations. There are a number of reasons that make good sense.

Will refi’s be different this time?

Should we expect to see 10,000 on the refi index again? While it’s impossible to say for certain I think we can look at the evidence and feel comfortable that we will not hit that level again.

As badly as the government would like to see a giant refi wave that puts more money in the pocket of the consumer they are some serious obstacles to that goal.

Back in 2002 EVERYTHING was different…and different in a way that was far more conducive to refi activity. The first and biggest factor is that 2002 falls smack dab in the middle of what we term the global mis-pricing of risk. Money was cheap and everyone was looking for a way to borrow and loan it out. Leverage was the magic that created earnings in this low rate environment.

In 2002 there were hundreds more mortgage companies than there are today. You couldn’t open your mailbox or check your voicemail in 2001-2003 without getting an offer to refinance your home. Money was cheap, mortgage companies were on every corner, new mortgage products were dreamed up that allowed EVERYONE to be able to refi. Sub-Prime, Interest-Only, Neg-Am, if you had a pulse you could get a mortgage in this most efficient of markets. No down payment? No problem, we’ll loan you that too. You don’t make enough to qualify? No problem, we’ll do a “no doc” loan. Can’t afford the monthly note on a traditional mortgage? No problem, we’ll do a sub-prime ARM and we won’t do a stress test to see what happens if rates go up. Helping this process along was an equally impressive shift in the securitization market for ALL of these mortgage products. Given the worldwide demand for yield in a low rate environment there was almost nothing that couldn’t be securitized and sold to someone…somewhere. Every type of mortgage that you could dream up was packaged, sliced, diced, rated and sold on down the line to an investor eager to take advantage of this market.

If you compare the efficiency and risk tolerance of THAT market to the market today you see significant differences. The first thing we can do is look at the mortgage “implode-meter”, a website that tracks the death of mortgage companies. The most recent update shows that since late 2006 there have been 342 mortgage companies that have gone belly up. That figure alone would indicate that we have less of a chance of returning to the go-go days of refi activity. The global financial meltdown that killed Bear Stearns, Lehman Brothers, Countrywide, Merrill Lynch, AIG, and tried to take down many more has obviously reduced the efficiency of the securitization market. So in 2009 we’ve got fewer people able to make mortgages, fewer people able to package and sell the mortgages, and fewer people willing to buy those mortgages. Those are some of the big factors that lead me to believe we won’t see quite the refi wave we saw the last go-round. I don’t know that it’s structurally possible to hit those levels first of all…even if it were you’d need enough willing buyers and at this point we’re seeing a markedly reduced appetite for risk world-wide. When the Fed has to step in to the market to buy over $1 Trillion in mortgage product it’s another sign that refi activity is struggling to take place on its own.

The big factor that supports higher refi activity in this market is that the government wants it to happen…and they now own significant portions of commercial banks. We’ve seen no shortage of plans from the government to ignite refi activity. From outright market manipulation in terms of the Fed buying MBS paper to push spreads down and buying Treasuries to keep the curve low, to congress pushing the idea of cram-downs and other half baked ideas.

To sell or not to sell

The question we need to answer is whether the government activity in this arena is enough to offset the structural changes in the mortgage and securitization markets, along with lower risk tolerances across the globe.

In my opinion we’ll see a heightened wave of refi activity but we won’t reach the lofty levels of 2001 through 2002.

Even if we don’t get back to the highs of the last cycle there are still issues to deal with. If you own MBS at premiums greater than 102 it’s worth a look at a rate shock to see how your cash flows and yields look. If you find something in the rate shock that you don’t like you probably have a gain and can sell it.

If you’d like us to run an analysis on your MBS portfolio just send us the information in the attached word document and we’ll run a custom analysis and get back to you.

To give you an idea of the changes in the market for Fannie and Freddie mortgage product I’ve attached the spread monitor that tracks the spread between new issue Fannie 15 yr MBS and the 5-year Treasury. At the height of the liquidity crisis this spread blew out to 311 basis points. This morning new issue 15 yr MBS are trading 169 bps over Treasuries. This spread tightening has translated into better prices on MBS securities. If you are wanting to sell…now is a very good time.

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