MBS MORNING: Prepayment Speeds Slow in January. EU Deficits Now in Focus

The dust is starting to settle after the initial knee jerk reaction to the Employment Situation Report.

Stocks are still dealing with yesterday's sovereign debt/jobs data/panic induced weakness. The S&P is currently -0.14% at 1060.

The dollar is holding onto yesterday's FLIGHT TO QUALITY rally, currently +0.46% at 80.283. (Global debt fears sent funds into the safest currency yesterday...yeh THATS RIGHT..KING DOLLAR!!! Last time I quote Larry Kudlow, I promise)

The 10 year Treasury note is trading above yesterday's levels. The 10yr futures contract has seen HUUUUUUUGE trading volume this morning. A nice level of support has been built in at 118-12.

118-12 is right about 3.60% in the cash market for 10 year Treasury notes. The 3.375% coupon bearing 10 year note is currently +0-05 at 98-07 yielding 3.591%. MG might say that trend channel is looking a bit bearish...its probably too soon to tell, especially because of the post-payrolls knee jerk price distortion.

In mortgage world, the FN 4.5 is +0-03 at 101-13 yielding 4.358%. The secondary market current coupon is 4.318%. These are new 2010 price highs for the FN 4.5s....

Prepayment factors were released last night.

From eMBS:

February factors indicated that January prepayments and issuance gave up recent gains, dropping for fixed-rate and ARM pools across all 3 agencies - Ginnie Mae prepays dropped in half from their year-end highs.  January fixed-rate issuance decreased by a combined $17B, erasing most of December's increases.

Freddie 30yr Gold CPRs decreased 3.5 CRP to 14.3 CPR, while 15yr Gold CPRs decreased 3.0 CPR to 14.5 CPR. Fannie Mae 30yr decreased 2.7 CPR to 15.4 CPR, 15yrs were down 2.5 to 13.9.  Ginnie Mae I 30yr prepays decreased 15 CPR to 13.3, Ginnie I 15yrs were down 5.7 to 9.6 CPR. Ginnie II Jumbo 30yrs were down 16.5 to 13.3 CPR, while Ginnie II 15yrs decreased 10.5 to 8.4% CPR.

Freddie fixed-rate issuance dropped $6.5B to $27.4B, Fannie Mae issuance decreased $7B to $33B.  Ginnie Mae I issuance decreased by $3B to $15B.

Ginnie II issuance decreased $1.2B to $18.9B, as Ginnie Mae issued a fourth Ginnie II Jumbo 30yr 5%  pool over $10B (4618M)  just as they did in December (4599M)  November (4578M) and October (pool 4559M). These 3 pools will no longer require manual factor updates on participants' systems, since Ginnie Mae changed their file format to accommodate these pools. Firms still using the old file format should verify the Original Face of these pools, which may be seen on our website.

ARM prepayments decreased for every product, most notably for Ginnie Mae Treasury-based ARMs which dropped by 15% CPR down to 13% CPR. ARM issuance continued to be slow, the only real activity being Fannie and Freddie LIBOR-indexed ARMs, and Ginnie Treasury-based ARMs.  See the attachment for a summary, and our website for details.

How does this affect MBS supply and demand technicals?

Prepayment speeds determine the timing of principle cash flows coming back to the MBS investor.  The faster the prepayment rate, the quicker  cash flows are paid back to the bond investor, and therefore the shorter the life of the fixed income investment. Conversely, when prepay speeds slow down, the average life of the bond's cash flows are extended. This occurs because of the embedded call option in mortgage-backed securities.

Plain and Simple: Only the borrower has the option to pay off their mortgage debt. If a borrower's mortgage rate is below current market yields, they will be less likely to refinance. If an investor buys a mortgage-backed security with cash flows supported by borrowers  that have mortgage rates  near current market, and rates unexpectedly rise, that investor will be holding an MBS that is unlikely to prepay because borrowers will have no incentive to refinance (because current market rates are higher). This is called extension risk.

Because prepay speeds were once again slower than expected or as slow as expected...certain MBS investors are moving  their positions "UP IN COUPON". They do so for a few reasons. One is to avoid EXTENSION RISK. The other is a function of greater returns relative to benchmarks. 

Cash flows from coupons in the “fuller” side of the coupon stack, 5.5s and 6.0s for example, have a shorter expected life than the cash flows generated from “current” coupon 4.0 or 4.5 coupon (see reason above). MBS returns are compared to those of a benchmark with a similar expected life (READ MORE). Since “fuller” MBS coupons are expected to prepay before “current” production or current rate MBS coupons, the cash flows generated by 5.5 and 6.0 coupons are compared to a benchmark with a shorter maturity date. For instance one might compare the yield of a 5.5 coupon to the yield of a 5yr TSY note.

For example:

The FN 5.5 is currently +0-02 at 106-09 yielding 4.083% (prepay speed: 15 CPR) with an average life of 5.55 years

The FN 4.5 is currently +0-00 at 101-10 yielding 4.340% (prepay speed: 5 CPR) with an average life of 11.33 years

Since the FN 5.5's WAL is 5.55  years, returns would be compared to those of a 5yr TSY note. The 5yr TSY note is currently yielding 2.262%. The FN 5.5 is yielding 4.083%. So the FN 5.5 pays a spread of 182 basis points over the  yield of its benchmark.

Since the FN 4.5's WAL is 11.33 years, returns would be compared to those of a 10yr TSY note (we use swaps but use TSYs in this example). The 10yr TSY note is currently yielding 3.60%. The FN 4.5 is currently yielding 4.34%. So the FN 4.5 pays a spread of 74 basis points over its benchmark.

Would you rather make an expected 1.82% over your benchmark or 0.74% over your benchmark????

YOU WOULD RATHER MAKE 182bps YIELD SPREAD!

Hopefully it makes a little more sense to you why MBS investors who chase returns (not managing duration gap) are moving UP IN COUPON today.  Relative to their benchmark, fuller MBS coupons are paying greater returns compared to those that one would expect to receive when investing in current coupon/new production MBS coupons.

And more importantly...

Me, Armando (dad), and Martin (my grandfather)  will be walking behind a snow blower all weekend! Again!! 

We went to the grocery store yesterday...you would have thought Safeway was having an early bird dinner special because I have never seen so many elderly folks in the grocery story at the same time. They were bumping into each other and fighting over who got the last of the polident.  THIS website just about sums up whats going on here right now. We are going to get pounded. On the bright side, this will give me the chance to act like a kid for the weekend. I will be sledding....

I have seen trade flows favor the seller as prices have attempted to push higher. Selling into strength after impressive appreciations is to be expected, especially on a Friday.

I suppose, now that the jobs report is behind us, the marketplace will put all focus on sovereign debt  anxieties abroad. Part of the reason for panic has to due with the size of deficits in specific EU countries and their inability to print new Euros to guarantee the timely repayment of debt they issue.  The US government can print dollars to cover deficits and back the AAA rating of their debt...Greece, Spain, and Portugal cannot do that, so when they attempt to raise money to fund their deficit spending, bond buyers demand a higher yield to compensate for added default risk. This increases the size of the deficit and raises investor doubts about those country's abilities to repay borrowed funds. This creates a downward spiral which usually requires some sort of bailout to correct. In this case, one has to assume the IMF is planning on intervening. In my opinion, this is a crisis of confidence. The market is making matters worse by pricing a "worst case scenario" into debt valuations. Some sort of headline news events is coming that will either make this worse or all better.

Rate sheets aren't much different from yesterday.