HSH Market Trends

Two-Month Forecast: October 20, 2008

Preface

We’re a little later than expected with this forecast. Frankly, there’s been so much going on in mortgage and financial markets, we forgot the self-imposed deadline of October 10. Oh well.

What’s happened since the last forecast? Well, the sweeping housing bill signed back in July has just started to kick in, but has since been dwarfed by other efforts. Fannie Mae and Freddie Mac were put into conservatorship by their regulator, effectively nationalizing their function in the mortgage market (buying loans from lenders to produce liquidity).

The Federal Reserve instituted a new Troubled Asset Relief Program (TARP) to help lenders sell bad assets to the government and clear off their books, and a new Commercial Paper Funding Facility (CPFF) was created to allow the Fed to support asset-backed and unsecured short-term credit markets.

In exchange for equity stakes, regulators directly injected $125 billion in the nation’s most significant banks, hoping to spur new lending.

Two global credit market spasms provided the impetus for a full-tilt run by investors to cash and cash-like investments, and central banks around the world have begun to pour cash into their own troubled institutions. Stock markets collapsed and revived (and are still in that sort of mode), oil prices have fallen by half compared to their recent peaks, and the Federal Reserve trimmed short-term interest rates in concert with other central banks around the globe.

And that’s only a portion of the headlines. With hundreds of pages of bills signed into law, there are probably any number of nuances yet to reveal themselves.

Recap

In our last forecast, we expressed optimism that we might be seeing some signs of stability in many markets. We were encouraged by moves put into place by the government and lessening inflation threats. Home sales have been a mixed bag, with existing home sales bouncing back and forth over and under the five million (annualized) level, while new home sales continue to touch new lows. New Home inventories are being worked down, albeit slowly, and spending for new residential projects actually revealed a slight spark in August.

Fannie and Freddie’s now-explicit backing by the government means that mortgage markets for good credit quality borrowers remain fully open, and there has been at least one signal that the tightening of credit for this audience has come to a halt.

For our last forecast, we thought that HSH’s Fixed-Rate Mortgage Indicator ((FRMI)) would travel a range between 6.65% and 7.15%. The actual distance between the low and the high was 6.52% to 7.08% (without the extra week in the forecast period, the top would have been 7.04%). As well, we thought that overall average for 5/1 Hybrid ARMs would trend between 6.45% and 6.85%, and got 6.31% to 6.80% as a response. We’ll call our late-July forecast “pretty good” and move on from there.

On a product-specific basis, conforming 30-year FRMs trended in a 63 basis point range, while their jumbo counterparts wandered in a 57 basis point gap.

Forecast Discussion

A year and a half into the credit market mess and new troubles keep emerging. Banks across the globe have exhibited new troubles in borrowing and lending; financial markets essentially slammed shut in August and September and have only recently been pried open a crack by extraordinary efforts. The complete lack of access to credit has taken a fairly mild economic downturn and suddenly made it severe, not only here but in major economies worldwide.

Oddly enough, American mortgage markets are among the best functioning financial markets at the moment, largely because so much effort was expended over the past 15 months (but especially in 2008) to ensure that their operation would continue. Other markets, such as overnight lending transactions, remain troubled, but seem to be responding to the unprecedented level of attention they’ve received over the past five or six weeks.

How fast they respond, and to what degree, is key to this forecast. Concerns over spiking LIBOR rates, for example, have re-aroused fears of ARMs resetting at less-affordable rates, with the potential for a new spate of mortgage failures as a result. If that spike in LIBOR proves short-lived, if government initiatives to influence overnight and near-term funding markets help them to perform more normally, the damage might be relegated to relatively few unlucky borrowers.

The Treasury’s injection of capital into banking institutions and their plans to begin to purchase billions of dollars of mortgage-backed securities should serve to both foster new lending and produce liquidity over time, but again, the question remains “how fast will any impact be felt by borrowers?”

It’s important to remember that there are two components of any financing deal: the availability of money, and the price of that money. Virtually all government efforts to date have been intended to ensure or improve the availability of money, but few (excepting the TAF) have been designed to influence any given price of money. For mortgages, and although volatile in this environment, the price of money remains at reasonable levels for borrowers who have access to it (good credit- quality borrowers). However, the availability of money for certain audiences (i.e., subprime) remains curtailed, perhaps severely so.

Risks, of course, influence the price of money. The risks of making a mortgage or investing in mortgages remain quite high (and perhaps rising) as none of the issues which have plagued the market have shown any signs of easing: foreclosures and delinquencies continue to rise, home prices continue to fall, credit quality continues to deteriorate and the economy is showing increasing signs of stress. All but the bravest investors have turned from this market, and those the do remain demand higher compensation to offset those risks.

Throughout these troubled times, access to mortgage money has been largely maintained, at least for the most creditworthy borrowers, but until and unless mortgages become a favored investment again, mortgage interest rates will have a tough time declining by much. Of course, Fannie and Freddie could use some of the $200 billion in capital they got to buy up mortgages at below-present-market rates, but they would probably be stuck with those low-yielding loans in their portfolio for some time since investors wouldn’t be very eager to snap them up.

While there are any number of complicating factors which could affect this forecast, it seems to us that at least two considerable opposing forces are in play. On one side are the drags of the economy and falling inflation concerns, which typically serve to pull down interest rates; on the other, troubled property markets and a stumbling economy (especially declining employment) make the risks of investing in mortgages more pronounced, pressing rates higher. The government’s backing of the markets means that mortgage money remains available — that is, liquidity is maintained, even improved — but the price of money will likely remains stubborn.

Forecast

We’ve argued for some time that a period of quiet would be of great benefit to the markets. With the whirlwind of new programs, policies and regulatory changes, this is probably even more the case now than before. Too much change, too soon and too broad, even while ultimately helpful, also serves to inject a certain level of anxiety into the market, and can also have unintended consequences (such as the mass-selling of Agency debt in favor of bank debt seen earlier this month).

An opportunity to review what’s been done and already in place and what’s coming on line now would likely allow for a less reactive marketplace, and perhaps a stabler, more proactive one. That could allow frazzled nerves a chance to calm, and could even foster lower mortgage rates as investors search for yield.

After spiking higher in mid-October, mortgage rates begin this forecast coming off elevated levels. Even though mortgage rates tend to decline much more slowly than they increase, the next nine weeks should feature somewhat lower rates on balance. We think that the overall average rate reflected in the 30-year FRMI should trend between 6.90% and 6.40% during the next nine weeks, and the overall 5/1 Hybrid ARM may travel between 6.70% and 6.25%. The Treasury’s plan of purchasing MBS in the market could produce some additional downdraft in rates (we hope), but there’s no way to know how much (if any) at this point.

We’ll talk again after Christmas, and we’ll review how close we were to reality.

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