For mortgage rate watchers and interest rate shoppers, last week was rewarding. Lenders were able to offer progressively lower mortgage rates as prices of mortgage backed securities moved higher and higher over the course of the week. By Friday lenders had passed along the best rates of 2010.

Improvements to consumer borrowing costs were partially a function of weakness in the equities market. Stock selling was sparked by political headlines including the Massachusetts Senate election, the announcement of new bank reforms, and growing debate surrounding the renomination of Ben Bernanke, the Chairman of the Federal Reserve.  All of these events combined to create a great deal of uncertainty in financial markets which forced investors to sell risky assets and re-allocate funds into risk free assets like of US Treasuries and Agency MBS.   By week’s end, most lenders were offering 4.75% as par for a 30 year conventional rate mortgage.  

The week ahead is filled with influential data points and noteworthy events. There is an FOMC meeting, $118 billion in Treasury auctions, several housing market indicators, and a read on Gross Domestic Product as the week comes to a close. All very influential events!

At 10am the NAR reported that existing home sales fell more than expected in December to an annualized pace of 5.45million.   This is the largest monthly decline since 1968!   More bad news from the report was the rise in supply of homes from a 6.5 months in November to 7.2 months in December.  READ THE MND STORY

Following the release, there was not much reaction in the marketplace as most investors are on the sidelines, waiting for an action packed week of data and events...

Tomorrow brings us another look at the housing sector with the S&P Case-Shiller Home Price Index. This data tracks the monthly change in the value of single family residences across the country.  Many economists believe that until home prices stabilize and start to increase, it will be very difficult for our economy to sustain growth.  This makes tracking home sales data much more important.   In addition to this data, we also get Consumer Confidence, a 2 year note auction totaling $44billion, and the beginning of the Federal Open Market Committee’s two day meeting where our nation’s monetary policy is set. 

Wednesday brings us MORE home sales data with the weekly Mortgage Bankers’ Associations Application index and New Home Sales.   This data will be followed by testimony from Treasury Secretary Tim Geithner to the House Oversight Committee and an auction $42billion 5 year treasury notes.  At 2:15pm eastern, the Fed Statement will be released. This statement sets the Federal Fund rate and gives an economic outlook and announces any changes to quantitative easing programs such as the MBS buying program.  Later in the evening, President Obama delivers the State of the Union address to Congress.

Thursday brings us

• Durable Goods Orders
• Jobless Claims
• $32billion of 7 year notes to be auctioned

Friday we get…

• GDP, the initial estimate of fourth quarter growth
• Chicago PMI
• Consumer Sentiment

For more on the week ahead, check out the MND STORY. AQ also wrote an outlook. READ MORE

Reports from fellow mortgage professionals indicate lender rate sheets to be worse than Friday.   The par 30 year conventional rate mortgage has risen to the 4.875% to 5.125% range for well qualified consumers.These rates are the most aggressive in the mortgage market, only very well qualified consumers will have access to these borrowing costs.  To secure a par rate you must have a FICO credit score of 740 or higher, a loan to value at 80% or less. These quotes also assume the borrower is willing to pay all closing costs including an estimated one point loan origination/discount/broker fee.  Your mortgage professional should be able to provide you with a breakeven analysis to determine the optimal fee vs interest rate. 

If you didn’t follow our LOCK advice from last week, that means you are still floating today. While lenders were likely conservative today, we are feeling extra defensive of last week's improvements. I am still favoring locking in loans. If you decide to float, keep a watchful eye on stocks. If they start to recover from last week's losses, mortgage rates should increase.

Mortgage rates ended last week at their best levels since early December. Then rates rose on Monday, gained back lost ground on Tuesday only to give back those improvements after the FOMC statement on Wednesday, weakness then extend over into Thursday. This left the par 30 year fixed mortgage rate in the 4.875 to 5.125 range. Today, all eyes were on the release of Advance 4th Quarter GDP.

At 8:30 am the US Department of Commerce released the advance read on 4th quarter Gross Domestic Product. This is the first of three 4th Quarter GDP release, today’s report will be revised in February and March. GDP is the broadest measure of total economic activity and includes every sector of our economy.   It is basically our economy’s score card.  A rapidly growing economy usually leads to inflation, so the bond market prefers slower growth while the stock market generally benefits from faster growth.  

The report showed that our economy grew much more than expected last quarter.  Economists were anticipating growth to expand at a rate of 4.6%,  the actual increase was 5.7%.  This is the fastest growth we've seen in six years.   On the flip side, in 2009, our economy contracted at a rate of 2.4%.  Included within this report is the Fed’s favorite gauge of inflation, the Personal Consumption Expenditure.   The core PCE, which strips out food and energy, rose 1.4% well within the Fed’s target range indicating once again that inflation is not an immediate concern.    Overall PCE rose 2.7% following last quarter’s 2.6% increase. There were a few caveats to this report though. READ THE DETAILS HERE

The next report to be released was the Chicago PMI.  This data measures the strength of business conditions in the Chicago region.  The Institute of Supply Management surveys both manufacturing and non-manufacturing firms, readings above 50 indicate an expanding conditions while readings below 50 indicate contraction.  Recent surveys have shown conditions improving with last month’s report coming in at 60.0, the highest reading in over 2 years and the third consecutive monthly gain.  Expectations for today’s report were for a slight pull back to 57.2.  The release indicated that business conditions in Chicagoland improved for the fourth consecutive month, beating expectations with a reading of 61.5.

Our final economic report of this busy week was a read on how consumers are feeling.  The University of Michigan’s Consumer Survey Center questions 500 households each month on their personal financial conditions and attitudes about the economy.   An optimistic consumer is more likely to spend which benefits stocks. A pessimistic consumer is more likely to save, which benefits the bond market.   Economists expected January’s final print to indicate an improvement in consumer attitudes with a read of  73.0.  The actual number: 74.4, consumer sentiment continues to improve.

Following the release of much better than expected 4th Quarter GDP, mortgage-backed security prices fell. This forced lenders to move mortgage rates slightly higher early on in the day. That didn't last long though. Around lunch time MBS prices began to improve. After the lunch hour, momentum picked up and lenders started repricing for the better. The par 30 year conventional rate mortgage rate ends the week in the 4.75% to 5.125% range for well qualified consumers. 4.75% is the best rate you will get in this market without paying several points.  To secure these rates you must have a FICO credit score of 740 or higher, a loan to value at 80% or less and be willing to pay all closing costs including an estimated one point loan origination/discount/broker fee.   You may elect to pay additional points to buy the interest rate lower or pay less in fees and accept a higher interest rate.  Your mortgage professional should be able to help you figure out the most optimal fee/rate structure for you based on your credit and how long you intend to keep the property. 

To lock or float is still the question. I have been saying LOCK all week, which would have worked out great for you, but I am willing to explore the possibility of floating over the weekend.Lets see...

In my opinion, 4.75% is probably the lowest rate we are going to see in the near future. For rates to move lower, we will need a fundamental shift in economic outlooks. This seems unlikely. Do you think the economy is going to take another nosedive this year? Combine that with the Fed's March exit from the MBS purchase program and mortgage rates appear to only have one direction to head: HIGHER

While I am not totally against floating over the weekend, I still can't provide enough justification to ignore currently aggressive mortgage rates, especially after lenders repriced for the better this afternoon. Think of this in terms of your payment over the next 30 years, unless you are floating a 729,000 loan, the marginal improvements we could see over the next week would not justify gambling against the growing risk of rising mortgage rates. LOCK WHILE YOU CAN STILL GET THESE AGGRESSIVE RATES.

The economic data calendar is busy next week, with the most important release, the Employment Situation report, due out Friday morning.  Should make for an interesting week.

These loans are about to make a splash in mortgage delinquency numbers.  They were issued en masse during the peak housing bubble years, approximately 2005 through 2007, and many of them are due to recast in the next several years, resulting in higher—often significantly higher—payments for borrowers.  Given the widely held belief that these loans were largely issued to borrowers wanting to buy more house than they could have otherwise afforded, the higher payments will be out of reach for many.  Because of recent home price trends and the negative amortization characteristics of these loans, the familiar result will likely be an increase in delinquencies, distressed sales and foreclosures. 

In order to provide some context to this problem, we have analyzed mortgage data to highlight the regions most exposed to the option ARM phenomenon.

A brief history of the problem...

During the peak of the housing bubble, a combination of speculation, low interest rates, easily available loans, and aggressive financial institutions fueled demand that pushed home prices to unprecedented levels.  Many areas experienced double-digit year-on-year price appreciation, with the predictable result that housing in these areas quickly became unaffordable for even relatively well-off buyers.  Option ARM loans, originally designed for borrowers with fluctuating incomes who wanted flexibility in making payments, became attractive for their low initial monthly payments tied to an initial teaser interest rate, enabling people to take on larger mortgages in the expectation that they could sell or refinance later.  These loans were most popular in the hottest mortgage markets where prices were rising fastest.  

Option ARMs typically give the borrower payment options for a specified period of time, typically including:

• A fully amortizing payment.
• An interest-only payment, covering one month’s interest but not the principal.
• A minimum payment, covering neither the principal nor the full amount of interest each month. The unpaid interest is added to the principal of the loan in a practice known as negative amortization.

When the buyer makes the minimum payment, the total amount of the loan grows each month.  Most option ARMs have a negative amortization limit ranging from 110% to 125% of the original loan balance; 115% is the most common setting.  When the loan reaches the negative amortization limit, it is recast, forcing the borrower to begin making fully amortizing payments based on a shorter amortization schedule and a higher loan balance than when the loan was issued.  An example of an option ARM recast and the resulting payment shock is shown in Figure 1.

Because the borrower has only been paying the minimum payment of $1,011.42, the loan will reach the 115% negative amortization mark in 51 months, nine months earlier than the scheduled recast.  The new, fully amortizing payment is based on a higher loan balance and shorter amortization period than the original loan.  The borrower will see their minimum monthly payment nearly triple to $2,780.20.

Given the falling values of most homes, option ARMs also create a situation of negative equity.  If we assume that our sample borrower originally put 20% down, the original home value would have been $500,000.  If we assume that property values declined by a mere 15% (many MSAs we examined declined significantly more), that would put the current value at $425,000.  Since the borrower now owes $460,000, this takes the borrower from 20% or $100,000 equity at origination to $35,000 negative equity now.  An unaffordable payment combined with negative equity is a situation in which a borrower may have an incentive to simply default on the loan.

Our analysis...

Most option ARMs were originated in the years 2005, 2006, and 2007.  Generally, these loans have a five-year scheduled recast (although some issued in late 2006 and 2007 have recast dates set at 10 years), which puts most of the scheduled recasts in 2010-2012, with roughly 50% of those happening in 2011.  Beginning with the Loan Performance ABS database (which includes only non-agency securitized loans, rather than those held in the portfolios of financial institutions), we limited our search to loans with typical option ARM characteristics, including any or all of the following:

• Negative amortization permitted
• Negative amortization limit
• Current balance higher than original balance

This left us with over 500,000 loans, which we narrowed to loans least likely to be able to refinance at recast, including loans that are:

• Delinquent with negative equity now
• Current with negative equity now
• Current with forecasted negative equity by scheduled recast
• Current with unknown recast time frame but within 5% of negative amortization limit

For the current loans, we included book years 2004 through 2007, and, if known, a scheduled recast between fourth quarter of 2009 and the end of 2012.  This left us with roughly 200,000 option ARMs we consider at-risk.  For the purposes of this analysis, we consider at-risk to mean a disproportionately high likelihood of default between now and the end of 2012.

Next, we limited the data to states with the most at-risk option ARMs—California, Florida, Nevada, and Arizona.  Loans in these four states encompass over 85% of the remaining at-risk option ARMs in our data set, with California having roughly 60%.  Finally, we limited the data to the 25 metropolitan statistical areas (MSAs) we consider to be the most distressed housing markets in terms of the number and concentration of at-risk option ARMs.  These 25 MSAs, shown in Figure 2, contain roughly 80% of the at-risk option ARMs in our data set.

As a note, there is an unknown number of option ARM loans currently held in portfolio by lending institutions.  We have seen estimates that as much as 30% of all option ARMs originated from 2005 through 2007 are held in portfolio.  Significantly less information is available about these loans; however, we believe they will only compound the overall problem of option ARM defaults.



Among the 25 MSAs we examined, we found there is dispersion in terms of the number and concentration of at-risk option ARMs.  As illustrated in Figure 2, the Los Angeles MSA has by far the most at-risk option ARMs.  However, in terms of concentration, as measured by at-risk option ARMs as a percent of all single family mortgages, the Los Angeles MSA is much less alarming than the Vallejo, CA MSA with a relatively high concentration of at-risk option ARMs.  The worst case, as is the case with the Riverside, CA MSA, is to have both a relatively high number, as well as a relatively high concentration of at-risk option ARMs.  

We believe a substantial number of these at-risk option ARMs will become delinquent, resulting in more houses on the market and putting further downward pressure on home prices.  As we know from recent experience, foreclosures have ripple effects, making it more difficult for others to sell or refinance their homes.  This could lead to increased volatility in the value of both collateral behind mortgage-backed securities as well as loans held in portfolio by lending institutions, creating the potential for further write-downs by lending institutions and increasing uncertainty related to the prices of mortgage-backed securities.  We may see intervention or action on the part of the federal government or lenders to postpone or prevent the at-risk option ARMs from going to foreclosure; however, if recent experience is any guide, these may not be sufficient to fully address the problem.  Of the loan modifications completed in 2008, approximately 52% were 60 or more days delinquent or in the process of foreclosure 12 months following modification[1]. 

Regardless, more housing sector pain may be on the horizon as a result of the coming option ARM recasts.  And, unfortunately, this phenomenon is likely to hit hardest in the housing markets that are already in the most distress.

Although lender's adjusted mortgage loan pricing by a few basis points yesterday, for the most part mortgage rates were unchanged as the bond market failed to make much progress in either direction. In the absence of economic data and noteworthy events, it was a pretty boring session yesterday. Both benchmark Treasury yields and mortgage-backed securities prices did however manage to make marginal improvements, perhaps I should say they didn't get worse instead as gains were minimal. Slightly improved is better than slightly worse though right?

The economic calendar is once again light today with the only significant data being the International Trade report. This data reports on the difference between the dollar amount of what our nation imports and the dollar amount of what our nation exports to other countries.   The report indicated our trade deficit widened 9.7% in November to $36.4billion, higher than economists expectations.   The larger deficit is being attributed to higher oil prices, something that is viewed as a manageable worry by the Federal Reserve.    Imports posted a 2.6% increase while exports rose for a seventh consecutive month by 0.9% indicating increasing demand for U.S. products overseas.    There was no reaction from the markets following this report.

There was another bit of news release this AM that is less mainstream than the above discussed Trade Balance release: the National Federal of Independent Business released their monthly optimism survey early this morning. This report gives us an inside look at the sentiment of small business owners, a group that makes up the majority of hiring in the US. According to the survey, small business optimism fell 0.3 points in December to 88. More importantly the NFIB notes that improvement has stalled. Here are a few comments from the NFIB chief economist:

•  “Continued weak sales and threatening domestic policies from Washington, have left small business owners with little to be optimistic about in the coming year.”
• “Capital spending is on the sidelines. Spending on capital projects remained at historic low levels, as did the demand for credit to finance such projects.”

This is not a great sign of things to come for the labor markets. It is also in line with our expectation that the housing market will experience a prolonged recovery process as unemployed Americans are unable to qualify for a mortgage!

So far today yesterday's modest improvements have extended over into today, however instead of being "modest", the gains have been substantial!

This has allowed lenders to improve mortgage rates this morning.

The par 30 year conventional rate mortgage remains in the 4.875% to 5.125% range for well qualified consumers.  To secure a par interest rate you must have a FICO credit score of 740 or higher, a loan to value at 80% or less and pay all closing costs with an estimated one point loan origination/discount/broker fee.

For a more indepth explanation of the underlying causes of this rally, READ MBS OPEN

At 1:00pm eastern, the Department of Treasury will auction $40billion of 3 year notes.   Since the supply is already known, market participants will look at the demand for our nation’s debt to gauge its success.   High demand, especially by indirect(foreign) bids, is one of the many factors that have attributed to mortgage rates holding near historic low levels despite record amounts of government borrowing.   Weak demand could pressure the fixed income sector lower today which could lead to worsened rate sheets this afternoon.  Matt and AQ will cover the results once the auction is complete on the MBS Commentary blog.As a reminder, tomorrow the Treasury will auction  $21 billion 10 year Treasury notes and $13 billion in 30 year bonds on Thursday.

Yesterday I advised that Thursday was the best opportunity to see noticeable improvements in mortgage rates. Thursday is the last Treasury aucton of the week, after this round of Treasury debt supply is taken down by the market, we are hopeful for some sort of a recovery rally. With that in mind I would recommend that you cautiously float. However if you have been waiting since early December to lock in your rate, I would strongly consider taking today's gains while you can get them because a relief rally is not guaranteed.

While there will be short spurts of mortgage rate improvements, we expect in the longer time frame (by the end of Q1 2010) that rates will hold over 5.00% and possibly even move higher.