How Is Unemployment Calculated?
Here in the US, the unemployment rate is estimated by a household survey called the Current Population Survey, conducted monthly by the Federal Bureau of Labor Statistics. The unemployment rate is calculated by dividing the number of unemployed persons by the size of the workforce. An unemployed person is defined as a person not employed but actively seeking work. The size of the workforce is defined as those employed plus those unemployed.

Largest Employer In U.S.
Who is the largest private employer in the United States? Wal-Mart! 2.1 million of us work there. In the public sector, the US Government employs about 2% of the nation’s workforce. The US Postal Service is the largest civilian employer, with about 600,000 folks. Private sector job growth continues to be the key to a sustainable economic recovery, especially if we expect to see much of an improvement in housing prices. Economists continue to believe the probability of a double-dip recession remains low, but are cautious. Heading into this employment data, most believe that if private sector job creation does not improve (or at least hold-up) in the near term, there will be significant ramifications on the economic horizon ranging from the outcome of the November mid-term elections to the likelihood that the Fed proceeds with an additional dose of quantitative easing.

Jobs Report Summary
The long-awaited payroll numbers came out, and Private payrolls rose 67,000 in August after a 107,000 increase in July. The unemployment rate rose to 9.6% from 9.5%, but it was a “good” rise in the unemployment rate since the participation rate rose to 64.7% from 64.6% and household employment rose by 290,000, the first increase in four months. Average hourly earnings were +0.3% month over month, better than consensus expectations. Although it is not a great number in the big picture, but it was better than expected. As you’d expect, the bond market had a bearish reaction, with 10-yr Treasury prices losing a point and moving up to a yield of 2.74%. Mortgage prices are worse between .250-.50. Look for things to become quiet and thinly traded as folks head out for the holiday weekend. Click Jobs Report tag below for full commentary and charts on today’s jobs report.

Mortgage Rates vs. Mortgage Bond Prices
Everyone knows that the prices reflected in the security market for mortgages are not being passed through to rate sheets. (If a Fannie 4% is trading at 103, plus a servicing-released premium, why isn’t a 4.5% loan priced at a 3 or 4 point rebate on the rate sheets?) Rate-sheet prices, however, are beginning to improve a little, relative to MBS prices, an indication that originators are possibly creating some capacity and attempting to grab some refi production volume. It isn’t 2002-2003 yet, for many reasons, but the mortgage market has a long history of “warming” when rates stay low for an extended period, finding ways to increase refi volume over time.

Pending Home Sales
Yesterday the markets were relatively quiet. Most of the price volatility happened in the early morning. The 10yr rallied off 4.00% early April to make new rate lows last week 2.42%. That’s a monster move by any measuring stick. Mortgages wound up Thursday down (worse) between .125-.250 with origination running at about $3 billion. Stocks rallied modestly, while the 10-year Treasury note worsened by almost .5 and its yield hit 2.63%. The Pending Home Sales Index for July rose 5.2% to 79.4 versus an expectation for a 1.1% decline – somewhat encouraging but no one is expecting a big upswing in prices.

No More MBS Buying From Fed
Rates continue to trend lower, helped yesterday by the release of the FOMC meeting’s minutes which alluded to the possibility of the Fed reinvesting in MBS’s. (But heck, as one trader told me, low mortgage rates are helping agency-qualified borrowers, not others in the economy like renters who can’t qualify, not those that don’t have jobs or those that simply pay cash for houses.) “A few members worried that reinvesting principal from agency debt and MBS in Treasury securities could send an inappropriate signal to investors about the Committee’s readiness to resume large-scale asset purchases,” the Fed said in the report, referring to mortgage-backed securities. The minutes from the August 10 meeting made it clear that the Fed is far from ready to restart Quantitative Easing Round 2.

FDIC Banks Report $22b Aggregate Profit
“It’s hard to make a comeback when you haven’t been anywhere.” Conversely, banks have certainly made a comeback: FDIC-insured institutions reported an aggregate profit of almost $22 billion in the second quarter of 2010, a $26 billion improvement from the $4 billion net loss the industry posted in the second quarter of 2009. This is the highest quarterly earnings total since the third quarter of 2007. Earnings remain low, however; the primary factor contributing to the year-over-year improvement in quarterly earnings was a reduction in provisions for loan losses.

Commercial Real Estate Update
“Commercial real estate markets showed surprising resiliency during the second quarter, with property transactions rising solidly and leasing activity holding up better than expected. We remain cautious in our outlook for commercial real estate and construction.” So states Wells Fargo’s economics department. “The rise in delinquency rates in recent years was mostly caused by the sharp contraction in employment, retail sales and the rate of household formation growth. The apparent improvement in demand may be overstated, as many firms are taking advantage of soft market conditions to upgrade space and locations. The larger immediate issues with commercial real estate continue to be the overhang of commercial real estate loans coming due over the next few years and the large number of development projects that have been partially completed or less, which continue to weigh on community bank portfolios. After showing some resiliency earlier this year, commercial real estate prices fell sharply in June.”

Mortgage Apps Up, ADP Employment Down
Today we’ve already had the MBA’s application index (apps were up 2.7% last week, with refi’s up 2.8% and purchases up 1.8%), and the ADP numbers which were down 10,000 but notoriously questionable about predicting overall employment data (the ADP # does not include government hiring).

In July Fannie Mae issued over $42 billion in new mortgage backed securities, up 6.4% from June, and the highest level of MBS issuance since February. Freddie, however, dropped slightly from June to July at about $26 billion, possibly due to a drop in the purchase of refi’s. Fannie reported that the serious delinquency rate (90 days or later) on its guaranteed single-family mortgages was down for the 4th month in a row, and fell below 5% for the first time since October 2009. Freddie’s serious delinquency rate on its guaranteed single-family mortgages fell once again, remaining below 4% for the second consecutive month.

Jumpy Rate Market Response To GDP & Home Sales Reports
Rates dropped 0.2% early last week then rose Friday to end the week even. The $109b in Treasury auctions throughout last week caused mortgage bonds to sell off slightly, and July’s record low New Home Sales (down 32.4% year-over-year) and Existing Home Sales (down 25.5% year-over-year) helped mortgages rally— rates rise on bond selloffs and drop on rallies. But then two factors caused a huge 59 basis point selloff Friday:

(1) The second of three 2Q2010 GDP readings showed the economy grew at 1.6% versus expectations of 1.4%. This was a big drop from both the first 2Q reading of 2.4% and the final 1Q reading of 3.7%. Normally economic weakness of this magnitude would cause a mortgage bond rally, bringing rates down. But the opposite happened because traders didn’t think the 1.6% number was weak enough.

(2) St. Louis Fed President and voting FOMC member James Bullard told CNBC that he thinks the Fed has “done as much as we’re going to do” in supporting the mortgage bond market. Remember: the Fed bought $1.25 trillion in mortgage bonds from January 2009 to March 2010, which has been the largest contributor to low rates since credit markets froze in 2007. Mortgage traders take Bullard’s comments seriously because, until now, Kansas City Fed president Thomas Hoenig has been the only FOMC member voting for tighter rate policies.

Rate Factors Week of August 30
Next week is packed with data: July consumer inflation, income and spending Monday; June S&P Case Shiller Home Prices, consumer confidence, and minutes from the August 10 Fed meeting Tuesday; payroll provider ADP’s jobs report Wednesday; June Pending Home Sales from the NAR Thursday; and the critical August BLS jobs report Friday.

After last week’s report that June-to-July Existing Homes Sales were down 27.2%, Robert Shiller (co-creator of the Case Shiller Home Price Index) said “this was the recording the month after the original closing deadline for the [homebuyer] tax credit, so it’s an anomalous month, but I do think that opinions about the market are weakening, and it may result in another decline in home prices going forward.”

Given the weight markets put on his Case Shiller Home Price Index, this Tuesday’s number should move mortgage bonds more than normal. As for Friday’s jobs report, estimates call for 105k job losses in August.

Weaker figures on next week’s data would normally help rates drop. But last week’s mortgage bond market reaction to the GDP figure shouldn’t be ignored: it was a very weak number but not weak enough in the mortgage traders’ eyes, so rates actually rose. Same goes for all data next week.

As discussed in the previous two WeeklyBasis reports (1, 2), mortgage bonds are overbought, very jumpy, and looking for any little reason to sell off—which would push rates up.

CONFORMING RATES ($200,000 – $417,000) – 0 POINT
30 Year: 4.375% (4.49% APR)
FHA 30 Year: 4.375% (4.50% APR)
5/1 ARM: 3.25% (3.37% APR)

SUPER-CONFORMING RATES ($417,001 to $729,750 cap by county) – 0 POINT
30 Year: 4.75% (4.87% APR)
FHA 30 Year: 4.5% (4.62% APR)
5/1 ARM: 3.75% (3.87% APR)

JUMBO RATES ($729,751 – $2,00,000) – 1 POINT
30 Year: 5.125% (5.24% APR)
5/1 ARM: 3.875% (3.99% APR)

Why Banks Aren’t Lending More
Why aren’t large depository banks loosening their credit guidelines and lending more money? Market watchers suggest that one reason is the buy-back issue: FNMA & FHLMC have sizable losses on bad loans and are considering forcing eleven large lenders (the biggest being BofA and Chase) to buy back loans which would result in losses of over $100 billion. Not only are banks grappling with that potential issue, but there may also be a lack of confidence in the health of our economy banks, businesses, and consumers. No one wants to borrow money to buy a house or expand their business if they aren’t confident about their job or more optimistic about the economy. And right now, as there often is, investors can’t seem to decide if the bond market (which is pointing toward further weakness) or the stock market (pointing toward stability and moderate growth) is more correct about predicting the future health of the US economy.

Is There A Bond Bubble & Are Rates Set To Spike?
Rates have an inverse relationship with fixed-income prices, meaning that when bond prices go up, rates go down. With the major drop in rates in the last several months comes talk of a “bond market bubble”. Most economists do not feel that we’re in a bond market bubble where there is a disconnect between prices and fundamental reality, but it is still worth talking about. All bubbles follow a common pattern, whether it concerns high-tech stocks, tulip bulbs, or real estate. Initially prices increase when a new opportunity presents itself with the prospect of good returns. Investors become more optimistic and lenders become less risk-averse. Suddenly everyone is chasing prices regardless of fundamental values, expectations become unrealistic, and speculators who are more concerned with short term gains rather than long term returns flood the market. But clearer minds begin to prevail, and insiders start to sell. Asset prices stop rising, panic sets in, and investors rush to unload positions before the next guy, and prices crash.

In the current case of fixed-income securities, however, fixed-income instruments like Treasuries are not new. There have been good returns, but any excitement is certainly tempered by the fact that the federal government will record a $1.3 trillion budget deficit in 2010, with fiscal year 2010 (ending 9/30) seeing Treasury debt issuance of about $2.3 trillion of which net issuance is about $1.7 trillion. At this point it appears that investors are buying bonds out of fear and from being defensive rather than being excited about bond prices rallying and rates dropping. And as we all know, there is little in the way of credit truly expanding – banks are holding onto their capital. Cash continues to be king – maybe the Fed should charge banks for holding onto capital.

Rates Not As Low As Mortgage Bonds Would Suggest
Let’s turn our focus to securities and pipeline hedging for a moment. What’s the scoop on 3.5% securities becoming more active? After all, the 4% coupon (which contains, basically, 4.25-4.625% mortgages) is trading around 103. 3.5% securities are near par. And when you throw some servicing value on there, whether it is .5 point or 1.5 points, it should present a rebate on the rate sheet for 30-yr mortgages around 4%. But this is not being reflected on the rate sheets, and the production is not there yet enough to calm fears of non-delivery issues. Volume in 3.5% securities has been steadily creeping up, and becoming more liquid, but seller’s are still timid of any kind of “short squeeze” if they sell 3.5′s out in November or December, and then rates slide up and they don’t have the production. On top of that, production is still in the mid-4′s, which goes into a 4% security. When profit margins start dropping a little, 3.5% volume should increase.

Who’s Profiting From Troubled Loans
Under the heading, “The more things change, the more they stay the same”, investment banks and “vulture funds” are garnering headlines for securitizing and selling troubled loans. The good news, of course, is that it helps keep the talk of a private mortgage bond market alive, and give servicers an outlet for their bad loans. The bad news, if you want to call it that, is that the pools are made up of delinquent loans rather than original liens. One can expect to see more news about companies with names like Penny Mac, Kondaur Capital, Allonhill, Residential Credit Solutions, Arch Bay Capital, Carrington Mortgage, Equifin Capital, etc., and probably ratings provided by the usual Fitch, Standard & Poors, and Moody’s. The process is more conservative this time around (although I don’t know precise details), with supposedly issuers having to set aside half or more of their assets as a cushion from loss, while the cash flow goes to the investors.

Market Update
Thursday started off somewhat quietly, but by the end of the day mortgage securities filled with rate sheet current coupon mortgages were better in price by .375. Just as there were numerous prices changes for the worse on Wednesday, the MBS market got it all back Thursday – woe to anyone who locked Wednesday instead of Thursday. And not only did all rates drop, but mortgages “tightened”, meaning they improved more than Treasury securities did. The $29 billion 7-yr auction went well (coming in at less than 2%!) at the same time that the stock market began to falter. Soon traders saw that investors interested in buying mortgages outnumbered sellers, with only $1.3 billion being sold.

Huge economic day today, and so far mortgage bonds are selling off, pushing rates higher.

Rates are up about .125% following a mortgage bond selloff late last week, but rates are still at unprecedented lows. There was very little economic news last week, and the selloff (which pushes rates higher) came as bond markets traded on two main factors that will continue next week.

Rate Factors Week of August 23
First is market calendar for the week beginning Monday, August 23. We have July’s Existing Home Sales (from the NAR) and New Home Sales (from the U.S. Census Bureau) Tuesday and Wednesday, then the second reading of 2Q2010 GDP and Consumer Sentiment on Friday.

These are all key reports that move bond markets, but they’ll be overshadowed by $109b in new Treasury bond auctions as follows: $7b in reopened 30yr TIPS Monday, $37b in 2yr notes Tuesday, $36b in 5yr notes Wednesday, and $29b in 7yr notes Thursday. This massive Treasury supply will disrupt bond markets and mortgage bonds may sell off, pushing rates higher.

How Long Can Low Rates Last?
Which brings us to the second rate factor for next week: bond markets realizing that their boom era can’t go on forever.

Last week I explained how government issues billions in new Treasury debt biweekly, why global markets have had such a big appetite for Treasury and mortgage debt over the past 18 months, and what might happen to rates if this bond rally reversed into a selloff.

A few days after those comments, Wharton finance professor Jeremy Siegel published a Wall Street Journal OpEd entitled The Great American Bond Bubble discussing similar concerns about an overbought Treasury bond market. He thinks a bond market selloff is imminent, and presented estimated investment losses for bondholders.

But you don’t have to be a mortgage or Treasury bondholder to experience investment losses. The rate increase that comes from a bond selloff is, in essence, an investment loss for consumers seeking mortgages.

The fragile global economic climate still justifies investors seeking the safety of mortgage and Treasury bonds, but Siegel is not alone in his sentiment, and markets can shift violently. If the U.S. had a debt crisis like they’re having in Europe, it would cause huge mortgage and Treasury selloffs and sharp rate spikes.

But the more likely scenario is a correction off current price levels for mortgages and Treasuries, and even this would push mortgage rates up .25% to .5%.

For now though, it’s still a full tilt U.S. credit boom, so consumer rates are stunningly low. The rest is whether a homebuyer can negotiate the right deal on a home in an area with price stability.

CONFORMING RATES ($200,000 – $417,000) – 0 POINT
30 Year: 4.375% (4.49% APR)
FHA 30 Year: 4.375% (4.50% APR)
5/1 ARM: 3.25% (3.37% APR)

SUPER-CONFORMING RATES ($417,001 to $729,750 cap by county) – 0 POINT
30 Year: 4.75% (4.87% APR)
FHA 30 Year: 4.5% (4.62% APR)
5/1 ARM: 3.75% (3.87% APR)

JUMBO RATES ($729,751 – $2,00,000) – 1 POINT
30 Year: 5.25% (5.37% APR)
5/1 ARM: 4.125% (4.24% APR)

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Rates Lower Still
Mortgage prices rising (agency MBS’s, not non-agency stuff). Not only are all rates dropping, but the spread between Treasury and MBS’s is still fairly tight – further helping mortgages. The demand for agency MBS cash flows is strong, but the primary market can’t churn out enough supply. Investors know that, on average, current mortgages have sparkling credit quality, and that the risk of investing in them is minimal since both Treasury and mortgage securities are firmly backed by the same entity: the US Government. Whatever spread now exists is based not so much on fear of default, but more fear of early pay-off.

Thursday saw a lot of selling in agency MBS’s, but on Friday it dropped off a cliff, nearing $1.2 billion. Regardless, rates continue down. The 10-year U.S. Treasury note yield fell to a fresh 16-month low in Europe today with weakness in Japan and in equity markets stimulating demand for U.S. government debt – we’re down to a yield of 2.62% (weren’t we just around 3%?) and mortgages are better between .125 and .250 in price this morning. Overall it’s a pretty decent news week. Today is the Empire State manufacturing index; tomorrow will be a bigger day with Housing Starts & Building Permits, Industrial Production & Capacity Utilization, and the Producer Price Index. Jobless Claims, Leading Indicators and the Philly Fed manufacturing index will be released on Thursday.

Mortgage Fraud Stories
We’re halfway through August already, and I bet time passes more slowly when one is serving time in prison: mortgage fraud in Seattle and Hawaii.

Better Rates At Smaller Banks?
“Want a Cheaper Mortgage? Go to a Smaller Bank.” I am not saying whether headlines like this are true or false, but these are what the general public tends to see.

“There are two sides to a balance sheet, left and right. On the right side there is nothing left, and on the left side there is nothing right.” On Friday Palos Bank and Trust Company, Illinois, was closed and First Midwest Bank, Illinois, assumed, with the help of the FDIC, all of its deposits.

Low Rates Causing Long Loan Turntimes
Lenders seem to be seeing the proverbial pig going through the snake. “Turn-around times are increasing, and anyone who qualifies and has equity is trying to refi their loan – and FHA borrowers with little to no equity are doing streamline refi’s which do not require an appraisal. In the case of FHA refi’s, they will all close at the end of the month because with FHA loans the borrower owes the existing lender one month of interest, which creates even more of a bottleneck near month-end.” But the general public seems distrustful of the origination community, this is compounded by a confusing regulatory environment, and at the same time lenders are frustrated with borrowers.

Mortgage Bond Positions Of Big Banks
The National Information Center has just released consolidated financial statements for bank holding companies for the 2nd quarter which provides a good early estimate of changes in bank assets and liabilities. The top 50 bank holding companies shed $32 billion of residential MBS’s during the 2nd quarter (agency and non-agency). This decline was led by the top four banks by total assets, whose net position in RMBS declined by the same amount. One bank dropped $22 billion of agency/conventional pass-through securities. Non-agency and commercial MBS holdings declined by $2.2 and $2.3 billion, respectively, for the top 50 banks, but GNMA holdings grew $4 billion and holdings of US Treasuries was up by $8 billion. So why did mortgage securities perform ok? Recent data suggests that banks added $40-50bn in MBS in the past month! Banks change their holdings often, and the report indicated that there was no industry-wide shift in the use of Agency MBS’s.

Normally this report is measured, but it’s hard to temper the current situation: we’re in an unprecedented government credit explosion. Low rate bonanza. Full tilt refi boom. Best time for homebuyers who select the right deal.

The ironic reason for this boom is that is that global developed economies are so unstable because of the last credit boom. But the late-1990s to 2007 credit boom wasn’t just loose monetary and fiscal policies, it was also loose credit standards born out of sweeping financial deregulation. We all know the story: Home loans made to unqualified (mostly U.S.) borrowers underpinned bond funds around the globe and countless derivatives were created from those bonds—and it all crashed when home prices plummeted.

At least this time credit guidelines are more strict, as any homebuyer or refinancer knows all too well. Getting a mortgage funded involves painstaking scrutiny of borrower and property profiles. The rewards, of course, are the rates. You can view current rates below and see this rate chart from 1971-Present.

But back to the irony. While it’s painstaking for a borrower to procure new debt, the government issues billions in new Treasury debt every other week, and global markets readily absorb it. Here are three reasons why Treasury and mortgage debt (which is, in essence, government debt too since Fannie and Freddie were taken over 2 years ago) has rallied so much recently:

(1) From January 2009 to March 2010, the Fed bought $1.25t in mortgage bonds to bid prices up and rates down.

(2) Then a European debt crisis from April to July caused bond investors to sell European bonds and buy U.S. Treasury and mortgage bonds.

(3) And the U.S. economy has posted two months of weaker jobs, GDP, home prices, retail sales, and consumer sentiment, causing money to move from stocks to Treasuries and mortgage bonds.

The result is record high mortgage bonds and record low rates.

This simply can’t last. Look at Europe. Right now we’re the beneficiary of their (many would say) profligate government debt issuance, but our gross federal debt is 75% of nominal GDP, according to Kansas City Fed President Thomas Hoenig. In a worst case, we’d eventually have a debt crisis of our own which would cause huge mortgage and Treasury selloffs, resulting in a very sharp rate spike.

Even in a moderate scenario where mortgages and Treasuries simply experience a market correction off current record highs, it would push mortgage rates up .25% to .5%.

But for now, it’s full tilt credit boom, and qualified mortgage borrowers are beneficiaries.

CONFORMING RATES ($200,000 – $417,000) – 0 POINT
30 Year: 4.375% (4.49% APR)
FHA 30 Year: 4.375% (4.50% APR)
5/1 ARM: 3.25% (3.37% APR)

SUPER-CONFORMING RATES ($417,001 to $729,750 cap by county) – 0 POINT
30 Year: 4.625% (4.74% APR)
FHA 30 Year: 4.5% (4.62% APR)
5/1 ARM: 3.5% (3.62% APR)

JUMBO RATES ($729,751 – $2,00,000) – 1 POINT
30 Year: 5.25% (5.37% APR)
5/1 ARM: 4.125% (4.24% APR)

Mortgage bonds closed up 19 basis points today following a Fed meeting where they kept their low rate stance. Mortgage lender rate sheets didn’t decrease commensurately as lenders held the line ahead of a 10yr Treasury note auction Wednesday and a 30yr T-Bond auction Thursday. Lenders do this because longer-dated Treasury auctions compete with mortgage bonds for buying attention, and can cause mortgage bonds to sell off which pushes rates higher. More on today’s FOMC meeting below.

The Federal Open Market Committee voted to keep the overnight bank-to-bank Fed Funds Rate steady at 0-0.25% and the overnight Fed-to-bank discount rate at .75%, citing subdued inflation that’s likely to continue for “some time.” For the fifth straight meeting in 2010, Kansas City Fed President Thomas Hoenig dissented on the belief that modest rate hikes now (in the form of overnight rate hikes and/or Fed selling of their massive mortgage bond portfolio) could avoid having to sharply increase rates later. The FOMC also said it wouldn’t start selling the $1.25t of mortgage bonds they purchased from January 2009 to March 2010, and they’d reinvest principal payments received on these holdings into Treasury securities—not selling mortgage bonds and buying more Treasuries with profits keeps yields (or rates) on mortgages and Treasuries low.

FULL FED STATEMENT
Information received since the Federal Open Market Committee met in June indicates that the pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls. Housing starts remain at a depressed level. Bank lending has continued to contract. Nonetheless, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated.

Measures of underlying inflation have trended lower in recent quarters and, with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature.

The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh.

Voting against the policy was Thomas M. Hoenig, who judges that the economy is recovering modestly, as projected. Accordingly, he believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted and limits the Committee’s ability to adjust policy when needed. In addition, given economic and financial conditions, Mr. Hoenig did not believe that keeping constant the size of the Federal Reserve’s holdings of longer-term securities at their current level was required to support a return to the Committee’s policy objectives.

FHA Mortgage Insurance Increasing October 4
FHA mortgage insurance will be increasing as of October 4, 2010 because the FHA insurance pool only has $3.5 billion in cash and Treasury securities left in its “capital reserve account” The money sitting in the CRA represents a 71% decline in just the last three months. The Mutual Mortgage Insurance Fund (MMIF) capital ratio has fallen below its statutorily mandated threshold. On the good news side of the ledger, from October through June the FHA had 19,310 fewer insurance claims on loans gone bad and paid $3.7 billion less than projected by the audit, perhaps due to solid foreclosure efforts although some feel that this is only because some states are experiencing a backlog in processing foreclosures.

Under HR 5981, FHA plans to adjust its annual mortgage insurance premium (effective with any new loans October 4) from .55% to 1.55%, yielding approximately $300 million per month in value to the FHA Mutual Mortgage Insurance Fund at a time when its reserves are perilously low. To offset this, FHA will lower its upfront premium from 2.25% to 1.25%. This will be effective for 30yr fixed loans. As you can guess, mortgage insurance companies are pleased with this news, since annual FHA premiums will be closer to annual PMI premiums and that could encourage lenders and borrowers to turn to non-FHA products for more mortgages. Borrowers currently shopping for FHA loans should revisit their strategy with their lender given this new news.

Treasury Won’t Increase Underwater Refi Stimulus
The rumor regarding a massive government-sponsored refinancing of over $1 trillion in loans continued to play in the market until it was shut down by a US Treasury official Thursday. The conjecturing, helped along by Jim Pethokoukis’ Reuters blog, spooked the market for high-coupon loans (at this point, anything 5.25% and above), and could certainly be construed as a political gambit. Investors, of course, are counting on that high yield for a few years, so a made-up threat of a huge refinance drove prices down by almost .5 in some areas. The loans that have not refinanced may not, so the risk in owning such high dollar price MBS’s is headline risk like this. “The administration is not considering a change in policy in this area,” said Treasury spokesman Andrew Williams.

Fannie Mae Negative $1.4b Net Worth
What is not a rumor, unfortunately, is Fannie Mae losing $1.2 billion in the 2nd quarter, and asking the U.S. Treasury Department for another $1.5 billion to stay afloat. At this point, are we supposed to say, “No.”? Optimists are quick to point out that this loss is much better than the nearly $15 billion Fannie lost in the same period a year ago. Regardless, this leaves Fannie with a negative net worth of $1.4 billion at the end of June. The company’s regulator, the Federal Housing Finance Agency, asked for $1.5 billion from the Treasury to eliminate the deficit and so the Treasury will buy another chunk of senior preferred stock from Fannie and bring its equity up to about $86 billion. Credit-related costs, which include provisions for loan losses, provisions for losses on loan guarantees and foreclosed property expenses, were $4.9 billion in the most recent quarter. That’s down from $18.8 billion in the second quarter of 2009, Fannie said.

Low Rates Lead To First 3.5% Mortgage Bond Coupon
A new coupon has been created: the Fannie or Freddie 3.5% MBS. Think of it as a bucket for 3.75%-4.125% loans.) Rates have not been this low before, so there was no need for the bucket/MBS coupon. But like someone feeling around in a dark room and not wanting to stub their toe, MBS traders and originators are being very tentative about trading this new 3.5% coupon. Most small and mid-sized mortgage banks are pricing hefty margins into these low note rates and selling this low coupon production on a best efforts basis, letting an accumulator such as Wells or BofA handle the risk. In this uncharted area, liquidity is critical, and the volume of bonds being bought and sold is being carefully watched as acceptance slowly grows.

Mortgage Bond Flows This Week
$2.4 billion flowed into the MBS market yesterday, with the lion’s share being 4% securities. (The 10-yr was up almost .5 in price and the yield closed at 2.91%, the 5-yr Treasury was better by almost .25 which was the same for mortgages.) Of particular interest to investors, however, was the release of the Fannie Mae prepayment speeds, since maintaining cash flows is important if an investor is going to pay a premium for a pool of mortgages. Overall early pay-offs were about as expected, but the recent lower-coupon production has seen a trend of paying off slightly earlier than had been hoped, which is causing some nervousness out there. That being said, lenders know that refinance volumes might be constrained by pricing in order to keep volumes manageable, so that there is a backlog of business out there – which causes even more nervousness among investors since prepays might pick up steam.

Jobs Report Influence On Fed/Markets
Today we had “the big employment number”, certain to influence the Fed’s meeting next week. The pace of the economic recovery continues to rely on private-sector employment growth, which is a problem since in the last 7 months the private sector added only 593,000 jobs. The ADP survey indicates that small firms (1-49 workers) represent about 45% of the level of employment, but accounted for only 16% of the increase in employment over the past five months. And Initial jobless claims have now fallen in three of the last four weeks, but remain stubbornly around 450,000 – weak.

Prior to this morning’s number, interest rates were about unchanged. The data was weak, pushing the dollar and the stock markets down, but has helped interest rates. Nonfarm payroll was -131k for July, with private sector jobs increasing 71k. The headline unemployment rate was at 9.5%, unchanged from June, and Hourly Earnings were +.2%. The yield on the 10-yr has moved down to 2.89% and mortgage security pricing appears to be better by at least .250 – we’ll see if investors pass that onto their rate sheets.

Daily Humor
Boudreaux, a good old boy from South East Louisiana, while not a brilliant scholar, was a gifted portrait artist. His fame grew, and soon people from all over the country were coming to South Louisiana to have portraits done. “Dah boy could paint dat stuff!” they’d say, and it looked good too!
One day, a stretch limo pulled up to his house. Inside the car was a beautiful woman, and she asked Boudreaux if he would paint her in the nude. This was the first time anyone had made this request of Boudreaux. The woman said money was no object; she was willing to pay $50,000.

Not wanting to get into trouble with his wife, Boudreaux asked the woman to wait while he went in the house and conferred with Clotille, his missus. In a few minutes, he returned and said to the lady, “I can do dat, ain’t no big thang. I’ll paint ya in da nude, but I gotta leave my socks on………. so I’ll have a place to wipe my brushes.”