signs of liquidity starting to emerge in the credit markets

the fed's steady, albeit very tardy, campaign to improve liquidity in credit markets and changes in the regulation of fre and fmn, as well as the fhlb system have improved liquidity in us agency mortgage bonds.

yield premiums of these securities have narrowed, but some investors warn that signs of better liquidity have not changed basic fundamentals plaguing housing finance, notably a steady decline in home prices amid rising defaults and foreclosures.

signs are pointing to things normalizing a bit from sheer madness recently. it does appear that the fed's objective of shoring up the agency market has been very effective. in recent weeks portfolio managers and wall street dealers have been ambushed within a market that was viewed as among the safest havens: the agency pass-through market. it is the simplest because these securities, as their name suggests, are engineered to merely pass monthly home owner principal and interest payments through to bond holders.

securities pooling home loans with guarantees by fre and fnm saw their spreads widen in february and march to levels not seen since 1986, the very early days of the mortgage bond market. agency mortgage bonds make up some 70% of the $10.5 trillion mortgage bond market.

to the surprise of many, even bonds backed by loans with a guarantee from gnma, a hud corporation, saw their yield premiums gallop to wider levels. while there has been ongoing debate about whether the agency mortgage bonds are guaranteed by the us government, the gnma-backed bonds are seen as having the full backing of the federal government.

much of the widening in agency debt came on the heels of massive selling by investors facing margin calls and dealer firms that had seized collateral. the first rounds of selling pushed spreads wider and this in turn spurred other margin calls and forced sales.

carlyle group's carlyle capital is believed to have been one of the casualties of this spread widening and the disassembling of carlyle capital's $22 billion agency mortgage bond folio is believed to have contributed to the dramatic widening in yield premiums. what made matters worse for the us mortgage market was concern about bsc, a notable presence in the agency and non-agency mortgage debt market.

that widening in yield premiums of securities backed by fnm, fre and gnma dampened liquidity and investors found they could not readily buy or sell securities. a mortgage bond salesman with a ny dealer firm recalls that the poor liquidity was at its worst in the weeks ended 3/14/08 and 3/21/08.

the widening in yield premiums of agency mortgage bonds has been evident since the beginning of the year, but the spread widening was at its worst in mid-march. in january, spreads of fnm's 5-1/2% mortgage pass-throughs were at 85 to 90 basis points versus 10-year swaps.

by 2/08, that yield premium was at 120 basis points, and in the middle of this month the spread was at 145 basis points. last week, the yield premium had narrowed to 115 basis points.

even with spreads narrowing to the 115 basis-point-over-swaps levels, "this is still a pretty bad quarter" for mortgage securities, says Ajay Rajadhyaksha, head of us fixed income strategy at barclays capital. however, many are now saying that things have definitely improved from the levels of late february.

not only did spreads widen, the ability to readily buy and sell agency mortgage bonds was dramatically impeded. this showed up in the bid offer spreads. at the height of the illiquid conditions the bid-offer spreads were as wide as 3/32 to 4/32, compared with 1/32 or 1/64 bid-offer spreads in normal market conditions.

some of that widening in bid-offer spreads was related to a reluctance among dealers to be active market makers. on sites like minyanville, stories abounded of dealers being less willing to bid on any paper; of dealers that were unwilling to accumulate any paper.

investors generally believe that the improved conditions in the us mortgage market -- the largest credit market worldwide -- are tied to a series of moves by the fed and agency regulators rather than a single factor.

for example, on 3/19 fnm and fre's regulator temporarily eased the agencies' surplus capital requirements from 30% to 20%. then, on 3/24 the federal housing finance board allowed a temporary increase in the amount of agency mortgage debt that the federal home loan banks can purchase.

at the same time, the fed has taken steps to shore up liquidity in addition to a series of rate cuts. the central bank last summer lowered fees it charged primary dealers when they borrow from the fed under the Securities Lending Program and it has continued since then to improve conditions in credit markets.

in march alone, the fed expanded its term auction facility to $100 billion from $60 billion and introduced a term securities lending facility that offered treasury securities to primary dealers secured for 28 days by a pledge of other securities including agency mortgage bonds.

the fed's primary credit dealer facility offered overnight loans in exchange for collateral such as mortgage bonds and asset backed bonds.

ubs published a report last week stating that the fed's actions, plus its intervention in the bsc takeover by jpm, has reassured markets that it is very aware of the liquidity and counterparty risk issues that plague the market and is taking action to alleviate the situation. in other words, the moves by the fed seemingly enable wall street dealer firms to more readily make markets.

the fed's moves improve liquidity. i think it sends a signal to the capital markets that ofheo believes the real level of capital within the gse's and their financial integrity is sufficient. as yield premiums for mortgage bonds shrink, this could lower mortgage rates for home buyers and home owners looking to refinance their mortgages.

this may be occurring already, as in the 3/21 week applications jumped over 80% and refinancings accounted for over 60% of loans processed by lenders. also, sentiment has been improved by expectations that there are some investors willing to stake money in mortgage debt, notably a new venture announced last week, pennymac, that is backed by blackrock and is run by former cfc executives.

the wider spreads may have hurt many investors, but they also provided a buying opportunity for some market participants. there are reports out there that investors are adding exposure, slowly. some have started looking at non-agency mortgage bonds, specifically AAA-rated classes of debt.

one fact that must be reversed to sustain any kind of recovery in the credit markets is declining home prices, as well as a steady pace of delinquencies and foreclosures. it is certainly possible that spreads will go back out if losses at fnm and fre rise to a level that raises issues about their ability to perform on their guarantee.

if i had to make a guess, i suppose no one should expect for a recovery, a meaningful one anyway, in housing prices this year. that looks like a 2009 story. however, markets like the stock market usually start trading much better about 6 to 9 months before the "real recovery." markets anticipate, after all.