FLASH UPDATE: TRV Weekly Commentary

TRV Weekly Commentary
Week Ending 21 Oct 2014

Comment:

Following last week’s dramatic risk-off sentiment and increase in volatility, we saw a moderate retracement as the 10yr sold off 9bps and implied volatility decreased 22bps. The basis performed well as investors cautiously added risk. The stack added 5-7 tics versus its 5 and 10yr hedges, as the curve moved in a parallel fashion. Despite the tightening, we remain bearish on the basis as we foresee increased volatility in the coming months. Additionally, we have seen average daily supply increase for three consecutive weeks to $2.7 bln, which is also a concern for the basis.

Primary rates hit 2014’s low on October15^th as the national average 30-year fixed mortgage rate fell below 4% to 3.93. The significant decrease in primary rates led to a 23% increase in the refi index, sparking fear of increased refi activity. Investors especially penalized slight premium benchmark IOs, demanding greater OASs for the perceived risk. FN30.350.10 widened 51 basis points this week, while FN30.400.10 widened 39 basis points. We anticipate spread widening for 3.5 IOs as refi optionality comes into the money on lower rates and increased vol. A 4/3.5 IOS swap may be a trade to watch to capture further spread widening in 3.5s.

Over the last two weeks, we saw spec pool payups on premium 3.5s increase, particularly on medium and low loan balance stories. Notably, payups increased 7+ and 6+ ticks for LLB 3.5s and MLB 3.5s, respectively. Also of note is the increase in the price of prepay protection for CR 4s as payups increased 10 ticks during the same period.[1]

Lastly, the FHFA outlined a plan to refine the Rep and Warranty Framework and provide clarity as to when the GSEs would exercise their remedy to require loan repurchase. The FHFA hopes that the plan will lead to lower perceived risk to originators allowing them to write loans more freely. The announcement caused little market action as it is expected to have a marginal impact.

Noteworthy:

In this week’s noteworthy section, we examine whether the payup on FNMA 4 LLB and MLB prices prepayment risk fairly. To analyze the price of prepayment protection, we used the FNMA 4 November TBA price as of 10/21 to calculate its OAS to swaps. We then priced LLB and MLB FNMA 4s of 2010 using the TBA OAS. We found that actual payups were more than one point cheap according to our prepayment and OAS model. We thus expect payups to increase as refi risk comes to investors’ attention.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

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[1] LLB and MLB collateral describes low loan balance and medium loan balance collateral. These collateral types typically offer prepayment protection as the dollar incentive to refinance is lower with lower mortgage balances.

CR collateral is 30yr collateral composed entirely of mortgages with LTVs greater than 125. High LTV implies prepayment protection due to perceived difficulty to refinance.