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Relative yields on mortgage-backed securities that guide new loan rates have fallen to the lowest in five months as investors wager the Federal Reserve is on standby to expand its holdings if the U.S. economy or Europe’s debt crisis worsens.

Yields on Fannie Mae’s current-coupon, 30-year bonds ended last week at 94 basis points more than 10-year Treasuries, the narrowest since July 8, according to data compiled by Bloomberg. The spread widened to 98 basis points yesterday after reaching 121 basis points, or 1.21 percentage points, on Nov. 24.

The Fed is already bolstering the market, adding "dollar roll" trades this month that lower financing costs for investors, after starting in October to recycle proceeds from past investments in housing-related debt to help real estate escape its worst slump since the 1930s. While a smaller share of economists predict the central bank will add to its $1 trillion of holdings as the U.S. grows, bond buyers may benefit regardless, said Dwight Asset Management Co.’s Paul Norris.

"Let’s say that something bad happens in Europe," said Norris, a senior money manager whose Burlington, Vermont-based firm oversees about $50 billion. "Initially mortgages may widen out a bit but what that would likely lead to is a really quick implementation of QE3," he said, referring to what would be the third round of Fed asset purchases called quantitative easing.

If the situation is reversed and "Europe gets its act together," benchmark interest rates would probably rise, benefiting mortgage-bonds spreads partly by reducing refinancing and the supply of new securities, Norris said.

Economists Forecast

While Federal Reserve Vice Chairman Janet Yellen, Governor Daniel Tarullo and Fed Bank of New York President William C. Dudley have signaled more mortgage-bond purchases are possible, economists say it’s growing less likely.

About 49 percent surveyed by Bloomberg News see the Fed announcing next year additional debt buying, down from more than two-thirds before the central bank’s November meeting. The Federal Open Market Committee meets today in Washington. Money managers are "overweight" on agency mortgage bonds by the most in at least two years, according to JPMorgan Chase & Co.

Elsewhere in credit markets, Caterpillar Inc. sold $600 million of bonds after the cost to protect the debt of the world’s largest construction and mining-equipment maker rose to the highest level in more than two years. U.S. interest-rate swap spreads widened as Moody’s Investors Service and Fitch Ratings said Europe’s leaders did little last week to fix the region’s debt crisis. Blue Coat Systems Inc. sought $465 million in loans as prices fell for a fourth day.

Caterpillar Swaps

Bonds of Charlotte, North Carolina-based Bank of America Corp. were the most actively traded U.S. corporate securities by dealers yesterday, with 77 trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Caterpillar’s offering consisted of $400 million of 1.125 percent notes due in December 2014 that yield 85 basis points more than similar-maturity Treasuries and $200 million of two- year, floating-rate debt that pays 30 basis points more than the London interbank offered rate, Bloomberg data show.

Credit-default swaps on Peoria, Illinois-based Caterpillar’s debt traded yesterday at 149.3 basis points, the highest since July 2009 and up from 118.5 at the end of October, according to data provider CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately- negotiated market.

Markit CDX Index

Benchmark gauges of company credit risk in U.S. and Europe rose after Moody’s said a European Union summit offered few new measures and doesn’t diminish the risk of credit downgrades on European nations. Fitch said a comprehensive solution hasn’t yet been offered and predicted a "significant economic downturn" in the region.

The Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, added 3.5 basis points to a mid- price of 125.4 in New York, according to data provider CMA. The gauge has climbed from 79 on Feb. 8.

The Markit iTraxx Europe Index of 125 companies with investment-grade ratings dropped 1.5 basis points to 184.25, according to JPMorgan at 11 a.m. in London.

Risk Gauges

The indexes typically rise as investor confidence deteriorates and fall as it improves. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The difference between the two-year swap rate and the comparable-maturity Treasury note yield increased 1.54 basis points to 43.93 basis points, the widest since Dec. 2. The measure, which rises when investors favor government bonds, has expanded from 41.55 on Nov. 30.

The Standard & Poor’s/LSTA U.S. Leveraged Loan 100 index fell 0.3 cent to 90.39 cents on the dollar, the lowest level since Nov. 29. The measure, which tracks the 100 largest dollar- denominated first-lien leveraged loans, has declined from 90.83 on Dec. 6.

Blue Coat, a provider of web security solutions, is seeking funding to back its buyout by Thoma Bravo LLC. The financing will include a $415 million term loan and a $50 million revolving line of credit, according to a Dec. 9 regulatory filing. Investment bank Jefferies Group Inc. is arranging the financing for the Sunnyvale, California-based company.

Emerging Markets

Leveraged loans and high-yield bonds are rated below Baa3 by Moody’s and lower than BBB- by S&P.

In emerging markets, relative yields rose for a second day, up 1 basis point to 409 basis points as of 10:08 a.m. in Hong Kong, according to JPMorgan’s EMBI Global index. The measure has ranged this year from 259 on Jan. 5 to 496 on Oct. 4.

The Fed, which under QE1 bought $1.25 trillion of mortgage securities and $172 billion of other agency debt through March 2010, has purchased a net $56.1 billion since October to offset prepayments and maturities, Bloomberg data show. The acquisitions are focused on the $5.3 trillion market of home- loan bonds guaranteed by government-supported Fannie Mae and Freddie Mac or U.S.-owned Ginnie Mae.

Anticipation of more transactions may be boosting demand among private investors. About 64 percent of money managers surveyed by JPMorgan are "overweight" agency mortgage securities, or holding a greater percentage than found in benchmark indexes, the highest since at least mid-2009, according to a Dec. 9 report by the New York-based bank.

QE3 Potential

Because of the potential for QE3, government-backed mortgage securities "offer that rare beast: positive exposure to event risk," Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC in Philadelphia, wrote in a Dec. 7 report. He recommended the bonds over other debt "within the interest rate sphere," such as Treasuries, in his 2012 outlook.

Chairman Ben S. Bernanke and his fellow policy makers will start another QE program next quarter, 16 of the 21 primary dealers of U.S. government securities that trade with the central bank said in a Bloomberg News survey last month. The Fed may buy about $545 billion in home-loan debt, based on the median of the firms that provided estimates.

A majority of 51 percent of the 41 economists polled by Bloomberg from Dec. 7 through Dec. 9 said the central bank will refrain from QE3. That contrasts with a survey before the Fed’s November meeting that showed 69 percent forecasting the action. This month, 13 percent of the economists said they expect the move will be announced in January and 21 percent in March.

Jobless Rate Falls

The likelihood has fallen after the unemployment rate declined to 8.6 percent from 9.1 percent, U.S. manufacturing expanded at the fastest pace in 5 months and vehicle sales climbed to their highest level in over 2 years.

A program may include $700 billion of home-loan securities, Citigroup Inc. analysts said. That figure reflects how much would be needed to "tangibly influence" mortgage rates without disrupting functioning in the market, analysts Inger Daniels and Mayank Singhal wrote in the Dec. 9 report.

Tarullo, in an October speech, said additional mortgage- bond purchases should "move back up toward the top of the list of options" because "the aggregate-demand effect should be felt not just in new-home purchases, but also in the added purchasing power of existing homeowners who are able to refinance."

Dollar Rolls

Yellen said in a Nov. 29 speech that she sees "see a strong case for additional policies to foster more-rapid recovery in the housing sector." If the Fed opted to buy more bonds, "it might make sense" for much of those to consist of mortgage securities to boost the housing market, Dudley said Nov. 17.

During the week ended Dec. 7, the Fed engaged in $4.35 billion of paired purchases and sales of mortgage securities in different months for the first time since starting to reinvest in the market along with its "Operation Twist" for Treasuries.

Those so-called dollar rolls boosted mortgage bonds last week, JPMorgan analysts led by Matt Jozoff and Morgan Stanley analysts Vipul Jain, Janaki Rao and Zofia Koscielniak said. The implied cost of financing Fannie Mae 3.5 percent bonds, which had climbed in a few weeks from about 30 basis points to almost 50 basis points, retraced that advance, according to JPMorgan.

Financing Rates

"Although funding markets in MBS have not shown significant signs of stress, financing rates have gone up in tandem with other funding rates, especially around year-end, and the Fed action helps alleviate some of those pressures," the Morgan Stanley analysts wrote in a Dec. 9 report.

With dollar rolls, an investor seeking to borrow money enters into contracts to sell mortgage securities in any month and then buy similar bonds the following month; a lender would undertake the opposite trades. Investors entering into transactions for other reasons may be on either side of the contracts.

The transactions will "facilitate the settlement of our outstanding MBS purchases," Jonathan Freed, a New York Fed spokesman, said in a Dec. 6 e-mailed statement.

The Fed’s use of the trades underscored the central bank’s commitment to supporting the market, Dwight Asset’s Norris said. "All of their speeches that I’ve read and all of the anecdotal evidence points to them being fully involved," he said.

While the central bank probably isn’t ready to announce additional mortgage-bond buying, it may provide new aid to the market if it details changes to its so-called communication strategy in a way that reduces expected interest-rate volatility, he added. Higher forecasted volatility damages investors by increasing doubt about when the debt will be repaid as projected homeowner refinancing fluctuates and by boosting hedging costs.

 

 

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BY BRIAN C. COESTER

REQUIRED READING: Here is the scenario: A homeowner spends $20,000 turning his home from an energy-sucking abode into an efficient, cost-savings oasis. This individual installs solar panels, ultra-efficient appliances, a tank-less water heater, energy-efficient windows and blinds, and paints the roof white. As a result, the property can now reap the rewards of almost no monthly utility bills while helping to improve the environment.
But what happens when the homeowner brings in an appraiser to value all of these new features? Do not be surprised if the appraiser tells the homeowner that the house isn’t worth any more than what it was originally.
This scenario is happening more frequently as homeowners and builders ride the atmospheric green wave to make homes more energy-efficient. There is a big problem here: The mortgage industry has not yet caught up with the green wave. It is going to take the support of both the mortgage and appraisal industries to ensure energy efficiency is valuable to the market and not just to the homeowner.
Admittedly, this is still a relatively new trend. Thus, the cost of building green is relatively high, and to a certain extent, the cost outweighs the short-term benefits. The average cost of installing solar panels on a home is $35,000 – and with an average savings of $1,700 a year, it would take approximately 20 years to recoup the total cost.
Furthermore, due to the lack of comparable sales and unknown actual cost savings by appraisers, it would be relatively difficult to evaluate the home’s energy efficiency. So what needs to be done to green up collateral valuations? There are several considerations that need to be addressed.
First, utility-bill data must be available on multiple listing services (MLS). Appraisers cannot take into account information they do not have. An MLS indicating a home is "green" means nothing to appraisers, thus making it very difficult for them to make adjustments due to unknown information.
In most states, home sellers are required to put 12 months of utility bills in the addendum of the contract. Having this information available for the appraiser on the MLS would enable an apples-to-apples comparison of the subject’s home and comparable. If a home that is "green" has utility bills that total only $1,000 a year versus a typical house that averages $4,000 a year, an appraiser is able to make tangible adjustments and give tangible value to the home.
Next, mortgage-backed securities need to give better pricing to green homes. The U.S. Department of Housing and Urban Development’s (HUD) Energy Efficient Mortgage (EEM) is a step in the right direction, but conventional lenders and the secondary market need to catch on. If lenders are concerned about the qualified residential mortgage requirements and the homeowner’s ability to pay the mortgage on a monthly basis, they should also be concerned with the utility costs.
The principal-and-interest payments on home loans do not change month to month, but utility bills do. Depending on the harshness of the weather, these monthly bills can skyrocket. 
Homeowners will default on their mortgage before they will have their heat or electricity cut off. Having homeowners with lower overall utility costs will make a significant impact on their monthly ability to pay the mortgage. For this reason, homes that are built with green items should get special pricing for being lower-risk. This would give homeowners an incentive to make the green upgrades – not only for a better mortgage product, but also monthly savings and a better environmental footprint.
Go green!
Furthermore, the appraisal industry needs to recognize the benefits of green improvements. The appraisal industry is quick to adapt to what lenders want and require, but it will not make the first move to create the curve. The industry needs to ensure that the market has clearly recognized that there is tangible value in energy-efficient homes before value will be given to them. 
Currently, there are no standards for valuing green homes. This makes it difficult to place a value on the property – after all, what are you comparing it to? Until the appraisers are supported with MLS information on recognized standards for the valuation of green homes and tangible evidence that the mortgage community places weight on green homes, appraisers will not be able to do anything.
Finally, green technology needs to be easily accessible to homeowners. Of course, this is outside of the control of lenders and appraisers, but it needs to be addressed. Energy-efficient technology is still fairly pricey, but over the next two to three years, it is likely that favorable price developments will be witnessed in solar power, solar thermal, geothermal and small wind solutions, as well as energy-efficient household appliances. If the price point is friendlier to the average homeowner’s budget, more homeowners will adopt the green home solution.
None of this will happen overnight, of course, but it is coming down the road. Lenders and appraisers need to recognize that this issue needs to be resolved before tomorrow’s solutions become more commonplace today.
Brian C. Coester is CEO of Coester Appraisal Group, based in Rockville, Md. He can be reached at (888) 485-1999.

(Photo courtesy of USPS)

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