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Strategies & Market Trends : The Epic American Credit and Bond Bubble Laboratory -- Ignore unavailable to you. Want to Upgrade?

To: Crimson Ghost who wrote (30380)	4/11/2005 2:39:30 PM
From: ild	Read Replies (1) \| Respond to of 110194

Berson's Weekly Commentary Economic Commentary April 11, 2005 Mortgage spreads. Analysts often use the spread between yields on fixed-income assets in order to determine things such as the relative supply and demand of various assets as well as the market's view of the creditworthiness of assets. Often these comparisons are with Treasury securities, which are assumed to have no credit risk -- as the U.S. government has never defaulted on a fixed-income instrument. Over time, the yield spread between a fixed-income instrument and a similarly dated Treasury security should change because of relative supply-demand conditions between these instruments, or because of changes in the market's view of the risk of default on the non-government security. (Note that the comparisons should be made with assets having similar expected lives, in order to keep the shape of the yield curve from affecting the spread). What does a look at spreads between mortgage yields and Treasury notes tell us? Between 1997 and 2004, for example, the spread between 30-year fixed-rate mortgage yields in the Freddie Mac weekly survey and yields on 5-year Treasury notes rose from 138 basis points to 241 basis points -- an increase of 103 basis points. This would suggest either that the demand for mortgage securities fell relative to Treasuries, or that the market expected mortgage defaults to increase. But is this a meaningful comparison for mortgages? Because mortgages (but not Treasuries nor many other private fixed-income instruments) are subject to pre-payment (i.e., mortgage borrowers can prepay at their option, and often do via refinancing when interest rates fall), mortgage market analysts focus on option-adjusted MBS spreads (OAS) to Treasuries rather than simple "spot" spreads in analyzing relative MBS yield movements. This adjustment is based on the value of the prepayment option, which in turn is based on both the slope of the Treasury yield curve and on the implied interest-rate volatility derived from prices in the options market. Simple spreads between MBS yields and, for example, 5-year Treasury note yields without taking these factors into account say nothing about whether option-adjusted MBS spreads are "wide" or "narrow." What do option-adjusted spreads look like over time? The chart below shows the option-adjusted spread as calculated by Lehman Brothers between Fannie Mae MBS and Treasury note yields from late-1993 to the present. Two things are immediately apparent: spreads today are slightly lower than they were in 1994 and there were a couple of periods in which spreads did rise sharply. These two periods were in late-1998 (corresponding to the financial market crisis associated with Long-Term Capital Management, the Russian debt default, and the Asian currency troubles) and in 2000-2002 (when federal budget surpluses resulted in a significant shrinkage of Treasury debt outstanding). In fact, spreads of all fixed-income assets to Treasuries rose in these periods -- in the first because of concern that the entire financial system would "melt down" and in the second because of a shortage of Treasury securities. Most mortgage market analysts began moving to the U.S. swap curve and away from the Treasury curve during this period for valuation and analysis because the sharp rise in spreads was caused only by too few Treasury securities. The chart also shows the Lehman Brothers estimate of the spread between option-adjusted Fannie Mae MBS and swaps (from 1998). The financial crisis in the fall of 1998 pushed these spreads up at that time, too, but over most of this period mortgage-swap spreads have edged down just a tad. When measured correctly (especially correcting for the impact of potential pre-payments on mortgage values), it is clear that mortgage spreads have not widened relative to other benchmark securities -- despite significant increases in the size of both the mortgage market and Fannie Mae/Freddie Mac portfolios. After last week's paucity of data, this will be a more active week for economic indicators -- headlined by retail sales and industrial production. On Tuesday, the trade balance for February is expected to worsen to $60.0 billion -- mostly because of higher energy prices. Also on Tuesday, the Treasury statement for March should show a deficit of around $70 billion -- a big improvement over the prior month, as income tax payments began to increase in the period leading up to April 15. On Wednesday, retail sales for March are projected to rise by 0.8 percent -- and by 0.9 percent excluding autos. Consumer spending remains a source of strength. On Thursday, business inventories are expected to climb by 0.6 percent, in February -- continuing to help push economic growth higher. Importantly, the inventory-sales ratio probably won't move by much, suggesting that firms will continue to add to inventories in coming months. Also on Thursday, initial unemployment claims are projected to drop further to around 325,000 for the week ending April 9th -- indicating a modest strengthening of the job market. On Friday, import prices for March should surge by 1.3 percent -- mostly from higher oil prices, but also because of the lower dollar. Also on Friday, the New York Federal Reserve Bank's Empire State Manufacturing Survey is expected to edge up to 20.0 in April -- indicating further strength in this sector. Additionally on Friday, industrial production and capacity utilization for March are projected to increase by 0.3 percent and to 79.6 percent, respectively. The industrial sector of the U.S. economy continues to recover. Finally, the University of Michigan's consumer sentiment index should slip to around 91.5 for the first half of April -- mostly because of higher oil prices. David W. Berson Fannie Mae Economics Last Revised: April 11, 2005 fanniemae.com