Closing Notes – Aug 17, 2010

17 Aug

Today was, relatively speaking, quiet on most fronts. Spreads have calmed down from the recent spike in volatility, but there still remains some elevated action in some of the underlyings

Sellers dominated the curve again today, pushing yields higher across the board, while Apache managed to issue new 30Y debt at T+140 and GM corporates were particularly active today given the IPO “debacle”.

US Indicative Close

2Y 51.3 +1.2, 5Y 143.4 +4.2, 7Y 205 +6.4, 10Y 264.6 +6.4, 30Y 376.9 +4.4

Spreads: 2s5 92.1 +3, 2s10 213.3 +5.2, 2s30 325.6 +3.2, 5s10 121.2 +2.2, 5s30 233.5 +0.2, 10s30 112.3 -2

Swap Spreads: 2Y 16.7 -1.2, 5Y 19.6 -1.2, 7Y 9.0 -1.4, 10Y -2.6 +0.6, 30Y -40.9 +2.6

Historical Volatility

10D HV

US Yields: 2Y 82 -5, 5Y 52 -1, 7Y 38 +5, 10Y 32 +7, 30Y 24 +3

Curve Spreads: 2s5 50 +2, 2s10 33 +8, 2s30 23 +2, 5s10 37 +1, 5s30 29 -3, 10s30 40 unch

30D HV

US Yields: 2Y 67 unch, 5Y 51 unch, 7Y 38 +1, 10Y 30 +1, 30Y 23 unch

Curve Spreads: 2s5 53 +1, 2s10 28 +1, 2s30 21 unch, 5s10 31 unch, 5s30 25 unch, 10s30 30 unch

Today’s Chartbook

With all the pretty volatile moves in rates lately, I though it would be helpful to visualize the carnage that has taken place, particularly in the flattening of yield curve spreads (second chart). The aggregate effect in the charts are shown, along with the magnitude (height of bars) for each respective instrument.

And, the obligatory yield spread chart, highlighted to show you the magnitude of the moves seen in the (once) nascent corner of bond trading, Government yield spreads:

And a chart showing the drawdowns from the January wides for most of the curve structures, with the exception of the mid/longs which have held up relatively well and have even reversed the longer term trends of flatter curves throughout 2010:

And another chart, comparing the monthly mean returns of the 2y vs. the 30y, a bit of a scatterplot if you will:

Economic Calendar

Relatively quiet in the US tomorrow, overnight there’s a couple items that may warrant your attention out of the UK, 4:30AM Eastern is the Monetary Policy Committee vote outcome from the UK. 7AM in the US brings the Mortgage and Refinancing indices, previous was 734.3 and 3993.0 respectively. As a note, the MBS market is on jitters about a wave of refinancing that may occur due to new political winds.

MBS Market Jitters

The MBS market is back on a new set of pins and needles over a wave of potential refinancings that may occur if several new policies designed to help homeowners are implemented. The main reason why is the way a MBS security works. For those who don’t know much about this market, when a MBS is constructed, people tend to look at a metric called PSA, which is basically just the sensitivity of the MBS to prepayments on behalf of borrowers. If a borrower pays an extra month on his mortgage, it has an effect depending on the “seasonality” of the loan. Typically at the beginning of a mortgage loan, the majority of the payments go to servicing just the interest, not the actual principal on the loan and as the mortgage becomes more seasoned, the monthly payments begin to repay the principal on the house. If said borrower starts paying 2x his monthly mortgage, the extra payment is counted as a prepayment, which alters the structure of the MBS. Typically MBS investors account for this “risk” by using the PSA and if the pool has a high chance of prepayments, which shortens the life of the entire mortgage pool, they demand an extra spread to compensate for the possibility that at year 30, the entire pool will have been paid off (assume this pool underestimated the PSA, and everyone theoretically were nice paying people and did extra payments, or sold their homes, the entire pool is paid off at year 20). You have to make up for that lost 10 years of monthly incomes. The whole prepayment risk is a rather lengthy subject, if you really want to know more about it, I suggest reading on of Frank Fabozzi’s books on the subject. Don’t let the thick size of the book fool you, you will enjoy reading about the nuts and bolts of fun structured fixed income products while you sip on a latte at Starbucks. I’ve tried to simplify the problem, but maybe I have confused some readers, and I’ve surely left enough out.

Most of the loans that are now in MBS pools are suffering from a different kind of risk – most people in the MBS sector were quite understandably very concerned about risk of default. With the new proposed plans, people will be able to make large payments to relieve the “burden” of making payments that have become too expensive given their financial situations (job loss, home value depreciation/underwater) by paying off a large portion or substantially all of their mortgages – ahead of the original term of the loan, which would mean that prepayment risk has now greatly increased. Even the Fed, with it’s 2 trillion dollars of mortgages is now concerned about prepayments that, it is speculated, they will buy Treasuries to compensate for the “lost” years after prepayments hit these mortgage pools. So, it’s easy to see why people active in the MBS sector are now concerned; this is probably what will be keeping the minions at the Fed and Treasury up again this fall. A risk that was largely ignored since the onset of the crisis thanks to our fine friends in Washington DC, has now made a grand entrance back into the ballroom.

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3 Responses to “Closing Notes – Aug 17, 2010”

  1. professorpinch August 17, 2010 at 10:46 pm #

    King, a couple of notes.

    1) Using my artist’s eye, it looks like the severity of yield moves has been tilted lower. While the number of days we’ve seen yields move up/down are roughly equal, the down yield days have *really* been down. Don’t know if it’s a fact, just my one good artist’s eye.

    2) The prepay thing is kind of shocking. I would’ve assumed prepays speeds would be about as slow as paint drying now. This also leads me to believe we should be seeing a lot of fresh paper come to market, right?

    Many Thanks.

  2. chibondking August 17, 2010 at 11:20 pm #

    Yes, recently the yield down moves, when they occur, occur with greater intensity. I debated using these kind of charts to depict it as it isn’t quite as clear (the whole aggregate effect could be a bit confusing). The alternative was a chart that looked like a spaghetti mess as I added more series. I’ll revise it, perhaps split it out into more manageable pieces.

    But i digressed. The moves are more to the downside (buyers) lately. You’ve given me a good idea: comparison of 2008 and mid 2009 moves with this and i’ll get back to you. It definitely should be interesting to see.

    On prepays.. They are indeed slow, but if policy shifts in DC towards throwing money at people to start paying for mortgages as opposed to the whole “workout” thing, which restructures the loan, but you still have a monthly payment that’s being passed thru to the MBS holders – you’ll see prepays accelerate as people either pay off the entire amount (through gov’t help) or starting to throw more money at the monthly payments. There’s also some interesting things (creative accounting) that I think could be mandated that would affect the cashflows of homeowners that go into mortgages.

    If there’s fresh paper coming to market, i’d be shocked. A scenario I think of is someone doing a refi on the property and the banks trying to shift it back off to the rmbs market (phlox maybe could explain the policy/legal aspect, I’m not sure the rules for banks regarding holding part of what they securitize is in effect yet or not). It sounds like the opposite, that you will reduce the amount of MBS outstanding if the winds in DC get their way. But, I haven’t even begun to scratch the surface of FNM/FRE/FHA. You may see more FHA paper come out into the market.

    Did that help?

    • professorpinch August 17, 2010 at 11:29 pm #

      It did, very much so. I haven’t kept up with the machinations in DC in this arena, but it doesn’t surprise me they thought the best thing to do was implement something that would throw *yet* another wrinkle into the process.

      Thanks, King.

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