Market Commentary August 6, 2013 Over the last few months, we have been witnesses to and participants in an extremely volatile mortgage market. While much of this volatility has been driven by the eral Reserve s monetary policy guidance, other key factors have caused a high level of uncertainty among investors. This commentary is intended to provide a recap of the mortgage market prior to the recent historic sell-off, the technical drivers of the move in rates, and how investor sentiment has shifted in this higher-rate environment. A Deeper Dive into QE3 In September 2012, the eral Reserve voted to launch a third round of Quantitative Easing (QE3) in an effort to jump-start the U.S. economy. With the unemployment rate hovering above 8%, the announced unprecedented measures to bolster the labor and housing markets by establishing an open-ended bond purchasing program of Agency MBS. Although the size of the QE3 program was originally set at $40 billion per month, it was modified in December 2012 when the FOMC announced that it would be adding $45 billion in U.S. Treasuries, for a total of $85 billion in monthly purchases. (This did not include existing monthly reinvestment of principal paydowns on the s current Agency debt and MBS portfolio, which could be up to an additional $40 billion in Agency MBS making the total size of the stimulus plan up to $125 billion in purchases per month!) Since neither announcement specified an end date to the bond purchases, this lead to many market observers referring to the program as QE Infinity. Once the began buying $3-4 billion in MBS per trading session, strong demand from hedge funds, money managers, REITS, banks, and foreign accounts lead to price appreciation in MBS. Also at that time, the markets were reacting to European debt widening, which sent investors fleeing to the perceived safety of U.S. Treasuries. In early-september 2012, even before the s announcement to purchase U.S. Treasuries, the 10-year yield hit a low of 1.573%. This benefited the housing market substantially by keeping mortgage rates at historical lows. In September 2012, shortly after QE3 was launched, 30-year fixed mortgage rates were posted as low as 3.25% and 15-year rates as low as 2.75%. This fueled a refinance boom (refi applications were more than 80% of total applications) that helped drive origination volumes higher. Many mortgage lenders posted record profits in 2012, helped by primary/secondary spreads which spiked as high as 145bps in early October 2012. Specified pool payups shot through the roof (which we discussed in a previous commentary) as investors looked for call protection on the high premiums they were paying on MBS. 2013 Fannie Mae. Trademarks of Fannie Mae. August 6, 2013 Page 1 of 7
10-Year Yield vs. FN30 3.0%: 09/01/2012 12/31/2012 By the end of 2012, with QE3 firmly in place, the s plan was doing what it had been created to accomplish. With both the fixed income and equity markets closing on a positive note, market participants had grown complacent in the view that demand was the new normal. After all, the FOMC was committed to stimulate the economy even long after stronger economic data showed signs of marked improvement. In the QE3 announcement it was stated, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. But, what about the s ultimate exit strategy? The Impact of Removing QE3 from the Market Less than three months after the QE3 announcement, the s policy stance began taking a different tone. In January 2013, the minutes from its December 2012 meeting showed that participants expressed the concern that additional purchases could complicate the Committee s efforts to eventually withdraw monetary policy accommodation... Also, economic data began to show signs of improvement with the November 2012 payroll numbers being revised up substantially to 247k from 146k. These two pieces of information spooked 10/24: investors who started to imagine the market without the s purchases. Mortgage dollar prices fell (by the 09/12: announces 12/07: Nov nonfarm payroll in December beats 2012) and the 10- end of announces January QE3 the FN30 3.0% was trading expansion with a of $103 QE3 handle vs. a $105 handle program to be effective in expectations. year yield rose above 2.0% for the first time since April 2012. This was the beginning of a series of yo-yo December events that frequently occurred this year, as both mixed economic data and signals from the have sent confusing messages to MBS investors. The monthly Nonfarm Payroll report and member comments (in meeting minutes, speeches, and Congressional testimony) have been two major drivers of interest rate volatility that the markets have been following closely for the last several months. While the Nonfarm Payroll number has been see-sawing back and forth in 2013 (stronger than expected data was reported every month except for January, March, and July), so has the. Tapering became a household word early in the year as other strong economic data prints were seen as indicators that the economy is recovering. This lead to Chairman Bernanke making several statements about raising and lowering the s bond buying based on economic conditions, introducing more uncertainty with investors. One example of this occurred in May during Chairman Bernanke s testimony to Congress on the U.S. economy. While his prepared testimony was comprised of relatively dovish comments, during the Q&A session, Bernanke commented that the could begin tapering the amount of purchases in the next few meetings if economic data continued to show material improvements. This seemingly innocuous statement (which was no different from the tone in previous comments) provoked a massive sell-off, as investors had now firmly grasped the idea that the would be scaling back MBS and Treasury purchases much sooner than planned as early as September 2013, by some estimates. So much for keeping policy accommodative for a considerable time after the economic recovery strengthens, per the QE3 announcement less than one year ago! To the s credit, however, attempts have been made to quell investor fears and bring some stability back after violent swings like this have occurred. Since May, several speakers have gone on the defensive with more dovish rhetoric that leans strongly on data dependence. 2013 Fannie Mae. Trademarks of Fannie Mae. August 6, 2013 Page 2 of 7
The Impact of Removing QE3 from the Market Less than three months after the QE3 announcement, the s policy stance began taking a different tone. In January 2013, the minutes from its December 2012 meeting showed that participants expressed the concern that additional purchases could complicate the Committee s efforts to eventually withdraw monetary policy accommodation... Also, economic data began to show signs of improvement with the November 2012 payroll numbers being revised up substantially to 247k from 146k. These two pieces of information spooked investors who started to imagine the market without the s purchases. Mortgage dollar prices fell (by the end of January the FN30 3.0% was trading with a $103 handle vs. a $105 handle in December 2012) and the 10-year yield rose above 2.0% for the first time since April 2012. This was the beginning of a series of yo-yo events that frequently occurred throughout 2013, as both mixed economic data and signals from the have confounded MBS investors. The monthly Nonfarm Payroll report and member comments (in meeting minutes, speeches, and Congressional testimony) have been two major drivers of interest rate volatility that the markets have been following closely for the last several months. While the Nonfarm Payroll number has been see-sawing back and forth in 2013 (stronger than expected data was reported every month except for January, March, and July), so has the. Tapering became a household word early in the year as other strong economic data prints were seen as indicators that the economy is recovering. This lead to Chairman Bernanke making several statements about raising and lowering the s bond buying based on economic conditions, introducing more uncertainty with investors. One example of this occurred in May 2013 during Chairman Bernanke s testimony to Congress on the U.S. economy. While his prepared testimony was comprised of relatively dovish comments, during the Q&A session, Bernanke commented that the could begin tapering the amount of purchases in the next few meetings if economic data continued to show material improvements. This seemingly innocuous statement (which was no different from the tone in previous comments) provoked a massive sell-off, as investors had now firmly grasped the idea that the would be scaling back MBS and Treasury purchases much sooner than planned as early as September 2013, by some estimates. To the s credit, however, attempts have been made to quell investor fears and bring some stability back after violent swings like this have occurred. Since May, several speakers have gone on the defensive with more dovish rhetoric that leans strongly on data dependence. 2013 Fannie Mae. Trademarks of Fannie Mae. August 6, 2013 Page 3 of 7
10-Year Yield vs. FN30 3.5: 04/25/2013 07/31/2013 05/02: April nonfarm payroll beats expectations. Market sells off 05/22: Bernanke testimony Q&A mentions tapering. 06/18: FOMC notes reinforces sentiment that QE3 could be curtailed in 2013 07/05: June nonfarm payroll beats expectations. Market sells off 2013 Fannie Mae. Trademarks of Fannie Mae. August 6, 2013 Page 4 of 7
How Higher Rates Have Set the Tone with Investors The tug-of-war between mixed economic data, signaling a slow economic recovery, and the comments made by the has been significant drivers of recent rate volatility. In spite of the continuing to stay the course on its monthly bond purchases for now, tapering expectations have been overwhelming MBS and Treasury rates, which have been steadily selling off since mid-april. With rates moving higher, origination has been declining at a steady pace (see table below). This means that the s current MBS purchases are an even larger portion of current production; one would expect to translate to tighter MBS spreads vs. the swaps / treasury curves in the wake of lighter supply. Purchase vs. Origination Week Ending* Prevailing 30 Yr Rate Primary / Secondary Origination Volume** Purchases*** vs. Orig Vol % Avg. Daily Orig Avg Daily Purch** 1/4/2013 3.625% 123 $9.50 $ 8.45 88.95% $2.38 $2.11 1/11/2013 3.625% 132 $12.30 $ 20.05 163.01% $2.46 $4.01 1/18/2013 3.625% 126 $12.50 $ 19.50 156.00% $2.50 $3.90 1/25/2013 3.625% 120 $13.00 $ 14.10 108.46% $3.25 $3.53 1/31/2013 3.750% 118 $14.30 $ 17.60 123.08% $2.86 $3.52 2/8/2013 3.750% 117 $13.90 $ 18.40 132.37% $2.78 $3.68 2/15/2013 3.750% 114 $12.40 $ 18.80 151.61% $2.48 $3.76 2/21/2013 3.750% 112 $9.60 $ 15.00 156.25% $2.40 $3.75 3/1/2013 3.625% 110 $17.00 $ 18.80 110.59% $3.40 $3.76 3/8/2013 3.750% 101 $12.70 $ 18.30 144.09% $2.54 $3.66 3/15/2013 3.875% 116 $11.00 $ 18.20 165.45% $2.20 $3.64 3/22/2013 3.750% 109 $12.90 $ 17.00 131.78% $2.58 $3.40 3/28/2013 3.750% 115 $11.10 $ 17.10 154.05% $2.22 $3.42 4/5/2013 3.625% 121 $12.10 $ 13.10 108.26% $2.42 $2.62 4/11/2013 3.500% 102 $18.00 $ 16.20 90.00% $3.60 $3.24 4/19/2013 3.500% 107 $14.30 $ 15.10 105.59% $2.86 $3.02 4/26/2013 3.500% 110 $13.60 $ 15.10 111.03% $2.72 $3.02 5/3/2013 3.500% 111 $17.60 $ 15.10 85.80% $3.52 $3.02 5/10/2013 3.500% 100 $15.10 $ 15.10 100.00% $3.02 $3.02 5/17/2013 3.625% 103 $12.80 $ 15.10 117.97% $2.56 $3.02 5/24/2013 3.750% 94 $13.10 $ 15.30 116.79% $2.62 $3.06 5/31/2013 3.875% 94 $9.90 $ 12.20 123.23% $2.48 $3.05 2013 Fannie Mae. Trademarks of Fannie Mae. August 6, 2013 Page 5 of 7
Week Ending* Prevailing 30 Yr Rate Primary / Secondary Purchase vs. Origination Origination Volume** Purchases*** vs. Orig Vol % Avg. Daily Orig 6/7/2013 4.000% 107 $9.20 $ 15.90 172.83% $1.84 $3.18 6/13/2013 4.000% 109 $10.70 $ 16.20 151.40% $2.14 $3.24 6/21/2013 4.375% 111 $12.90 $ 17.40 134.88% $2.58 $3.48 6/28/2013 4.500% 114 $10.50 $ 17.50 166.67% $2.10 $3.50 7/5/2013 4.500% 111 $6.00 $ 16.90 281.67% $1.50 $4.23 7/12/2013 4.500% 107 $7.40 $ 13.30 179.73% $1.48 $2.66 7/19/2013 4.500% 113 $8.60 $ 15.80 183.72% $1.72 $3.16 7/26/2013 4.500% 109 $7.90 $ 15.40 194.94% $1.58 $3.08 8/2/2013 4.500% 108 $8.00 $ 15.50 193.75% $1.60 $3.10 Avg Daily Purch** * purchases are reported from Thursday to Wednesday. Origination volume is tracked Monday to Friday. ** Origination volume is an estimate only and represents what we track on the desk. Data is sourced from the volume we see or from street sources. It may not represent 100% of the actual origination volumes. ***Gross Purchases A consequence of the purchases outpacing supply was large shorts in the TBA market and elevated dollar roll levels in current coupons. Primary dealers found it difficult to cover large shorts owed to the, making MBS even more expensive as supply was not able to meet demand. This was exacerbated by the TMPG enacting a fails charge in 2012 which sent dealers scrambling to find bonds to deliver to the at SIFMA settlement dates. For example, in early May 2013 the did not purchase any 4.0% securities because 4.0s only made up 1% of origination volume at the time. The FN30 4.0% May/June roll was 2.625/32nds on May 1. Fast forward to current market (07/31) and 38.6% of purchases and 88% of new originations while the FN30 4.0% Aug/Sep roll is 9.625/32nds. In spite of this overwhelming supply technical, mortgages have continued to underperform, becoming an unfavorable asset class to own. This is because many MBS investors were hit extraordinarily hard by the spread widening, causing increased selling and overall reduction in MBS holdings through the second quarter of this year. REITS, for example, entities that utilize high degrees of leverage (borrowing), were faced with substantial margin calls as the value of securities they pledged for loans lost value. This caused forced selling of their most liquid assets, including MBS, to meet those margin requirements which counteracted the supply technical. This selling sent the price of MBS securities even further down, and hence, creating the vicious cycle of more margin calls. Also, banks, which have historically been large buyers of MBS, are faced with new capital holding requirements under Basel III which make owning securities more difficult due to higher mandatory loss reserves. The decreased demand had a profound impact on GN/FN swaps. The GN/FN 4.0 swap was by far the most volatile dropping two points from 81/32nds to 19.375/32nds over a three-month period. The table below shows the drop in GN/FN swaps week over week from May through July 2013. 2013 Fannie Mae. Trademarks of Fannie Mae. August 6, 2013 Page 6 of 7
GN/FN Swap Levels Ticks 90.00 80.00 70.00 60.00 50.00 40.00 30.00 20.00 10.00 0.00 GN/FN 3.0 GN/FN 3.5 GN/FN 4.0 Week Ending The sustained sell-off over the last several months has left the mortgage market in a very different position than where it was when QE3 was announced in September 2012. As of the end of July 2013, 30-year fixed mortgage rates were being posted around 4.5% vs. 3.25% (Sep 2012) and the primary/secondary spread is near 108bps vs. 145bps (Oct 2012). Refinance applications only make up 63% (07/31) of total mortgage applications compared to over 80% in 2012. The predominant hedge coupon is now FN30 TBA 4.0s (88% on 08/02) vs. FN30 TBA 3.0s (-28%). The FN30 4.0 is trading at $103-26 which is almost 2 points lower than where FN30 3.0s were trading in October 2012 ($105-30)! Market participants believe that the will begin tapering their purchases in Q3 or Q4 of 2013 and potentially end the program in 2014. If current investor apathy persists, it will be interesting to see who will step in and begin to replace the demand. In summary, due to the open-endedness of QE3 and market expectations, more clarity is needed in its tapering message before investors may show increased interest in MBS. This is a concern given that recent reports showed that investors withdrew $43 billion from taxable bond mutual funds in June 2013. Going forward, lenders and originators may be faced with an extremely volatile market with speak and economic data driving large intraday swings in mortgage prices and mortgage performance vs. swaps / treasuries. The opinions, analyses, estimates and forecasts relating to the outlook expressed above are those of certain traders on Fannie Mae's Sales Desk (the " Sales Desk") and should not be viewed as projections or predictions of value, performance, or results, nor as legal, tax financial, accounting or other advice. They should not be construed as indicating Fannie Mae's business prospects, corporate strategies, or expected results, and are subject to change without notice. Although the Sales Desk bases its opinions, analyses, estimates, forecasts and other views on information it considers reliable, it does not guaranty that the information expressed above is accurate, complete, current, or suitable for a particular purpose, and it should not be relied upon as such. These opinions, analyses, estimates, forecasts and other views of the Sales Desk represent the view of that business unit as of the date hereof, and do not necessarily represent the views of Fannie Mae or its management. We do not undertake to update any information presented above, or to communicate any changes in opinions or estimates expressed herein. 2013 Fannie Mae. Trademarks of Fannie Mae. August 6, 2013 Page 7 of 7