This past week was a memorable one for the Treasury market that saw yet another record amount of paper coming to the street in addition to the long awaited end of the Fed’s $300 billion Treasury purchases program.
The supply started on Monday with a $7 billion reopening of the current 5 year TIPS benchmark, that was pretty uneventful. Despite a slew of deflationary factors in the market, inflation protection is in pretty serious demand. The bid/cover ratio was over 3 for the first time since the first 5-year TIPS auction in 1997.
Demand for new paper this week peaked on Tuesday as a record $44 billion in new two-year notes were auctioned with a bid/cover of 3.63 versus a 6 month average of 3.07. This is unbelievable to me. In one day the U.S. Treasury sold debt equal to the size of the GDP of The Dominican Republic, and there was still a line of unfilled buyers out the door. A shift in the source of demand really stood out as domestic investors dominated the auction for the short duration bonds. U.S direct buyers took 26.1% of the auction versus an average of 5.7%. Indirect bidding (or foreign demand) typically takes the largest slice of short term auctions, given the bias foreign central banks have toward the shorter end.
The $41 billion 5-year auction on Wednesday saw demand come back down to more normal levels, and although demand continued to wane on Thursday with the $31 billion seven-year auction, the week was an overall win for the Treasury considering the $123 billion total weekly supply.
The Treasury securities portion of the Fed’s QE also ended on Thursday. As you all are well aware of short term rates are extremely low, and Tuesday’s especially strong two-year auction is good evidence of how far we are from a significant shift in policy that will eventually move the short end, but as we lose a major buyer of intermediate term bonds the longer portion of the curve remains a concern for the market. The housing market is depending heavily on low intermediate term rates, and as the homebuyer credit is slowly phased out, which seems to be likely, low mortgage rates will be the only crutch for credit demand to stand on. The big question now is, “Was the Fed that crutch?”
Housing Market
This week I stumbled upon the graph below from the San Francisco Fed showing the rise and fall of non-agency mortgage backed securitization over the past decade. The graph below shows the distribution of market share of new mortgage origination since 2000.
Source: San Francisco Fed
http://www.frbsf.org/publications/economics/letter/2009/el2009-33.html
Some excerpts from the report:
· According to Federal Reserve flow of funds data, the banking institution share of total mortgage assets declined from a peak of about 75% in the mid-1970s to about 35% in 2008. Much of the decline in banking institution housing portfolios over this period was related to the expansion of the government-sponsored enterprises (GSEs) Fannie Mae, Freddie Mac, and Ginnie Mae.
· At its peak in late 2007, non-agency securitizations accounted for nearly 20% of outstanding mortgage credit.
· Non-agency securitizations were much more likely to involve adjustable-rate mortgages, including option ARMs, to be rated as subprime, and to have less-than-full documentation of borrower income and assets.
· In the fourth quarter of 2006, approximately 10% of originations in our sample were labeled by originators as "subprime." For the entire universe of mortgages, subprime loans are estimated to have made up about 20% of originations in 2006. By the first quarter of 2008, the subprime share was effectively zero. Since then, increased FHA lending—identified here by Ginnie Mae's share—has revived this segment of the market.
The graph is pretty incredible. The rapid growth and even more rapid contraction of the non-agency sector are directly correlated to the rise and fall of real estate prices. The ease with which non-prime borrowers could secure non-traditional forms of financing, proved to be beneficial to all parties involved… as long as property values continued to appreciate. When that segment fell apart during the initial stages of the credit crisis massive amounts deleveraging ensued, affecting more than just housing.
Even though non-agency securitization is still a non-player in mortgage lending, the government has stepped in to pick up the slack. As evidenced by the huge surge in GNMA market share since mid 2007. It tough to be bullish on the prospects for housing outside of the government tax credit programs and government subsidized lending. The sustainability of a recovery in the housing market is dependent on sources of demand that are also sustainable. Reinflating prices, or simply putting a quick floor under prices, provides little to be positive about further out.
Cliff J. Reynolds Jr., Investment Analyst
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