The Week Ahead in the Capital Markets

November 26, 2008

Sometimes you’re the windshield; sometimes you’re the bug. After being the bug for so many months, the mortgage industry finally had its day as the windshield.

First, the bug. “My occupational hazard is that my occupation’s just not around,” sings Jimmy Buffett (A Pirate Looks at Forty) in a refrain all too familiar in the mortgage industry. Last week ended with fixed mortgage rates a whopping 3.15% above equivalent Treasury yields. The spread hit a mid-week high of 3.45% and all appeared to be lost.

The Mortgage Bankers Association publishes an index of mortgage lock activity each week – last week it was so low that it felt like every day was the day after Thanksgiving. The index closed the week at 376, a level usually saved for mid-holiday doldrums. For some perspective, the index is usually around 650, and was 1800 in the heydays earlier this decade. In an industry used to having $2 trillion years, last week’s pace was less than $1 trillion, the lowest in more than ten years. 

According to a new study sponsored by Inside Mortgage Finance, nearly one in seven home sale contracts nationwide were cancelled during September and October because buyers were unable to obtain mortgage financing. Sales of distressed properties – those involving real estate owned (REO) or so-called short sales – made up more than 40 percent of home sale transactions occurring over the past two months, the study found. Potential home sellers remain in denial about the true value of their homes.

Now, the windshield. After this morning’s dramatic Treasury announcement, fixed mortgage rates plunged by more than 0.50%. The average conforming rate closed the day at 5.50%, a level at which $2.5 trillion of mortgages are eligible for refinance and origination, even after you consider credit restrictions and home price declines. It is time to break out those “Refi 2008” t-shirts.

Three components drove today’s action. First, the Treasury announced that it would purchase up to $100 billion of Fannie and Freddie debt (the debt that the agencies issue to finance their mortgage purchases). The problem in the past few weeks has been that the Treasury guaranteed bank debt, but not agency debt.  So of course everyone bought bank debt to the detriment of mortgages.  The result today?  The yield on agency debt dropped 0.34%, and guess what — the spread between mortgage and Treasury yields dropped by the same amount.  The spread closed today at 2.80%.  Second, the Treasury announced that is would purchase up to $500 billion of Fannie, Freddie, and Ginnie securities, which further pumped up mortgage prices.  Third, Treasury yields dropped (the five-year Treasury yield closed today at 2.05%).  These three phenomenon combined to create a whopper of a day for mortgages.  CMC patrons locked almost a month’s worth of loans today alone.

In related news, the Treasury decided to enter the commercial banking business.  It announced a program to finance hundreds of billions of dollars in car loans, student loans, and business debt.  The Treasury will form a government bank(!) and seed it with $20 billion of TARP funds.  The Federal Reserve will lend the new entity up to twenty times that amount to create loans.  Of course the bank regulators would shut down a private institution if it were levered twenty times, but never mind that.  These are truly incredible times. 

“You seem to be flying a $700 billion plane by the seat of your pants.” – Rep. Gary Ackerman, D-NY, as the House Financial Services Committee took pot shots at Henry Paulson.   The $700 billion bailout of the banks has undergone more transformations in less time than any government program ever dreamed up .  Paulson has embraced the Willie Sutton approach of grab the money first and then worry about what to do with it.  Finally, however, some of the money is having a positive effect on the mortgage industry. 

Mortgage rates might stay low for a while.   The yield on two-year Treasuries last week fell below 1% for the first time ever, and longer-term yields posted their biggest drop since October 1987.

At the same time, the yield spread between 10-year nominal Treasuries and 10-year Treasury inflation-protected securities, or TIPs, collapsed to just four basis points, another record low. That means the market is expecting essentially no inflation over the next ten years – and that is why many predict Fed Funds will drop to 0% and stay there for most of 2009.  There isn’t much risk of higher Treasury yields any time soon.  Goldman Sachs economists warned Friday that the unemployment rate will rise to a jaw-dropping 9% from 6.5% currently.  As a result, the 10-year-note yield could fall as low as 2.75% in the first quarter of 2009, reports Barron’s . 

As for stocks, the carnage continues.  If stock-market movements followed the normal distribution, like human heights, an annual drop of 10 percent or more would happen only once every 500 years, whereas in the case of the Dow it has happened in 20 of the last 100 years.  And stock-market plunges of 20 percent or more would be unheard of—rather like people a foot and a half tall—whereas in fact there have been eight such crashes in the past century.   When the S&P went below 804 last week, the percentage decline off the highs marked the greatest bear market in history since the Great Depression.  The S&P 500 index dividend yield, about 3.79%, exceeded the 10-year Treasury yield.  For the first time in half a century, the dividend yield is higher than the bond yield.   Stocks are cheaper than they were, but they could get a lot cheaper.

Perhaps today is a turning point, and the constructive efforts of the new administration have begun.  And not a moment too soon.  Since Sept. 24, when Obama opened up a nine-point lead in the race, the Dow fell 19%.  In order of urgency,  most analysts call for Obama to support a bold new stimulus package, aid for Detroit, foreclosure relief, a delay on tax hikes, free trade, new financial regulation, fuel-efficient cars and fair rules for union votes.

Another good day for the stock market yesterday.  Up almost 400 points.  If we keep this up every day for the next three years, we’ll almost be even again.   – Jay Leno

Happy Thanksgiving.  Thanks for your business and have a good week. – Tom Millon

About Capital Markets Cooperative
Capital Markets Cooperative (CMC) provides mortgage bankers with the economies of scale and the expertise to reduce risk and maximize profit in the secondary market. Regarded as the premiere secondary marketing specialist in the industry, CMC has worked with financial institutions nationwide to break traditional barriers in capital markets and take performance and profits to the next level. To date, CMC executives have managed more than $500 billion of mortgage volume. CMC board members are Tom Millon, Jeff Harry, and Harold Koegler.

For more information about Capital Markets Cooperative, visit www.capmkts.org or call 904.543.0052 or e-mail info@capmkts.org. This e-mail is not a solicitation or investment advice of any kind. You may change your e-mail address, or if this e-mail has reached you in error, or you do not wish to continue receiving it, please let us know by replying to tmillon@capmkts.org.