As Yogi Berra so wisely observed, “It’s tough to make predictions, especially about the future.”

2009 saw catastrophe averted.  In sharp contrast to conditions a year ago, stocks, gold, and crude oil are higher, market volatility is lower, and the yield curve is steeper.  Recall that in early 2009, the Dow was plummeting towards 6500 and credit-sensitive products of all flavors were in a tailspin.  A mortgage refinance boom, a stock market rally, and a once-in-a-lifetime credit recovery followed.  Mortgage originators (especially those in the CMC group) reaped the rewards of high volume and wide margins.

In what turned out to be the market story of 2009, investors that bought credit products generated historic profits.  So much so that bargains are hard to find today, and credits could worsen in the months ahead.  Evidence of the credit recovery can be found almost everywhere, including the non-agency mortgage market.  See below that rates on jumbo loans are much lower today than they were a year ago.

The fate of mortgage rates rests largely in the hands of the Fed.  They will either continue to buy mortgages, or they won’t.  They will either raise the Fed funds target, or they won’t.

The Fed recently discussed extending its purchase program beyond the end of the 1st quarter, but is unlikely to continue buying MBS all year.  In the words of PIMCO’s Bill Gross, “They will stop buying.”  When the Fed’s bid goes away, the spread between mortgage and Treasury yields is (obviously) likely to rise.  By how much?  Estimates range between a 0.50% and 1.00% increase.  Today’s spread is just below 2.00%.  I wouldn’t be surprised to see the spread could easily creep towards 2.50% this year, taking conforming mortgage rates near 6.00%.

Katy bar the door if inflation, growth, or a combination thereof triggers more aggressive Fed action.  A 6.00% mortgage rate assumes the Fed increases their funds target as expected – the futures market predicts a funds rate of 1.00% a year from now.  Here’s a tip:  things almost never go as expected.  Recall that in the beginning of 2008, Fed funds traded at 4.25%, a level below the median funds rate of the past ten years.  If the Fed returns funds to historical norms, mortgage rates could push well above 6.00%

While we worry about the GSE’s support for MBS in 2010, we need to eventually offer alternatives to our absolute dependence on the GSEs for a mortgage market.  Right now we are in a self-reinforcing circle of cause and effect…

1. The economy is still bad, both because of and contributing to the residential real estate slump.
2. On Christmas Eve, the Treasury committed to an uncapped support of the GSEs, in large part due to their losses from One above.  So, the American taxpayer is on the hook for an unlimited amount over and above the then-current limit of $400 billion and, more importantly, all mortgage investors will (and should), treat Fannies and Freddies as “full faith and credit” of the U.S.
3. Treasury support of the GSEs in Two above may allow them to buy defaulted loans onto their own balance sheets and allow for more effective loss mitigation and a better functioning modification program for homeowners.  Many pundits are looking for wholesale reduction of mortgage balances with a cost of approximately $2 trillion, (yes, that is with a ‘t’).
4. The provisions of FASB 166 & 167 going into effect as of Jan. 1 mandate that the GSEs take their MBS issuance on balance sheet as issuers retains risk and the GSEs guarantee repayment of all principal.  Freddie Mac alone has approximately $32 billion (only a ‘b’ this time) of reserves against delinquent loans.   Clearly the GSEs can’t buy that kind of volume of loans and put them on their balance sheets without significantly more assistance from the Treasury.  The Christmas Eve announcement allows the GSEs to do precisely that.
5. On the other hand, private label securitization has been almost non-existent in the past few years and is not being helped by accounting issues in Four above.  Very few issuers want, or can bring securitizations on balance sheet, particularly as Congress, regulators and the Treasury have been mandating issuers keep some of the risk in any securitization.  We may not care except that…
6. Securitization has been about 40% of all the credit in the US in the past 15 years and the economy is not dealing well with the sudden withdrawal of liquidity occasioned by Five; bringing us back to our fragile economy in One above.    It would be better to have a few alternatives for consumers, certainly with adequate regulation to prevent the imprudent practices that caused the bubble and, by the way, with government policies that also do not encourage bubbles.  The banking system, which is lending as best as they can, does not seem to have sufficient capital to take up the slack for securitization, nor the regulatory approval to invest so heavily in long term mortgages.  A healthy securitization market, with the right restraints, will benefit consumers, investors, banks, GSEs and, indeed, the US government as we work our way out of this mess.

“Even if the bomb works, there’s going to be 72 very disappointed virgins.”   – Jon Stewart on the Underwear Bomber

Happy New Year, thanks for your business, and have a good week.              — Tom Millon