Real Estate Third Quarter 2014 Supplement

REAL ESTATETHIRD QUARTER 2014

INTRODUCTIONWelcome to the latest edition of Bloomberg Brief: Real Estate focused on the

main trends in the residential and commercial markets.

In this issue, former FDIC Chief William M. Isaac explains how the latest recov-ery differs from prior cycles and why the home price rebound has been muted. Fannie Mae’s Tom Seidenstein and Steve Deggendorf outline their expectations for credit standards in residential housing finance, and Bloomberg economist Josh Wright explains why MBS spreads won’t widen much as the Fed reins in purchases and housing agencies trim portfolios.

Then there are what Michelle Meyer, economist at Bank of America Merrill Lynch, refers to as the “Boomerang Borrowers.” These former homeowners who lost houses through a foreclosure or short sale and want to return as owners are finding that credit is harder to get. This in turn could have an impact on de-mand for new and existing homes. As Meyer points out, nearly 17 percent of all homeowners with a mortgage in 2006 fell into either foreclosure or short sale.

On the residential and commercial real estate finance side, the picture con-tinues to improve. Financing costs for office and retail property borrowers have dropped thanks to lower AAA- and BBB-rated CMBS spreads.

Some of the narrowing in CMBS spreads is tied to demand from investors looking for extra yield at a time when U.S. Treasury 10-year debt yields 2.36 percent and the 30-year yields just over 3 percent.

The yield hunt may also explain lower CMBS issuance. According to Jefferies’ Lisa Pendergast, a greater number of investors financed commercial property purchases and retained the loans on their own balance sheets rather than sold them. This forced participants to cut expectations for 2014 CMBS issuance.

The appetite to put money to work in commercial real estate finance shows up in other ways, notably heightened use of interest-only and partial IO loans. Just over half of the mortgages resold into CMBS so far this year allowed borrowers to pay just interest, or had partial-IO characteristics.

– Aleksandrs Rozens, Editor

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HOUSING UNCERTAINTY ERODES ECONOMY Uncertainty about regulation has crimped hous-ing finance and other types of lending, which maybe dampening the U.S. economy, says FTI’s Wil-liam Isaac. PAGE 6

BOOMERANG BORROWERS Demand for housing from consumers who lived through foreclosures will be modest, according to Michelle Meyer, senior U.S. economist at Bank of America Merrill Lynch. PAGE 8

CMBS ISSUANCE OUTLOOKLisa Pendergast, co-head of CMBS strategy at Jefferies, says issuance may fall short of expec-tations as lenders keep loans on balance sheets instead of reselling them as bonds. PAGE 9

CREDIT STANDARDS EXPECTED TO FALLA decline in application activity likely will prompt mortgage lenders to ease credit standards, ac-cording to Tom Seidenstein and Steve Deggen-dorf at Fannie Mae. PAGE 10

MBS AND THE FEDDemand for residential mortgage bonds is expected to be robust enough to rein in MBS spreads even as housing agencies wind down their portfolios and the Fed pulls back from MBS, writes Bloomberg Economist Josh Wright.PAGE 12

REFINANCINGS AND CMBS LEVERAGE Refinancings, a key source of profit for lenders, have not bounced back even as mortgage rates skirt historic lows. Use of interest-only and partial IO loans accounted for just over half of all com-mercial property debt resold into CMBS. PAGE 13

FOCUS ON HOMEBUIDERSSome homebuilders may benefit from recent policy moves aimed at expanding the availability of mortgage credit. PAGE 14

HOME PRICES AND MBS TRENDSBloomberg’s Michael Morrissey looks at the future direction of U.S. home prices and whether MBS spreads are rich to swaps. PAGES 16-17

AGENCY COLLATERAL AND CMBS SPREADS The amount of agency debt resold into CMBS fell, reflecting a pickup in private label financing of multifamily properties. CMBS spreads narrowed on demand from investors looking for extra yield and issuance of commercial mortgage bonds rose. PAGES 18-19

CMBS ANALYSIS Bloomberg application specialist Ting Chen looks at how CMBS are impacted by retailers that have announced store closures and retail property mortgage loan to value ratios.PAGE 20

CAP RATES Cap rates for retail property loans and hospitality loans fell. Office property cap rates rose to a high not seen since the first quarter of 2012. PAGES 22, 24

FOCUS ON REITSApartment REITs have turned to development in lieu of acquisitions to fuel growth and some of that was reflected in September’s 19 percent jump in multifamily building starts. Office property values are getting a boost in demand from non-U.S. buyers. PAGES 25-26

RESIDENTIAL MORTGAGE DELINQUENCIESDelinquency rates for U.S. single-family mort-gages fell in the second quarter of 2014 from year-ago levels, while low borrowing costs failed to stoke buyer requests for home loans. PAGE 28

COMMERCIAL PROPERTY DELINQUENCY, FORECLOSURE RATESIndustrial property foreclosure rates dropped to lows not seen since April 2010 and hotel delin-quencies were unchanged in the second quarter. PAGES 30-31

TOP UNDERWRITERS OF DELINQUENT MORTGAGE DEBT Among underwriters of commercial mortgage loans resold as CMBS, LaSalle had the largest number of delinquent loans as of Aug. 4. PAGE 32 PRIVATE EQUITY AND HEDGE FUND MANDATES An increasing number of fund of funds are seek-ing to put money to work in hedge funds that invest in mortgage backed securities. PAGE 34

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BY THE NUMBERS4.16% rate for 30-year fixed rate mortgage loans in September 2014.

4.49% rate for 30-year fixed rate mortgage loans in September 2013.

Source: AIA, Freddie Mac, MBA, Fannie Mae, National Association of Realtors

$8 billion net equity cashed out during refinances of conventional home mortgages in the third quarter of 2014.

$5.6 billion net equity cashed out during refinances of conventional home mortgages in the second quarter of 2014.

$84 billion net equity cashed out during refinances of conventional home mortgages in the second quarter of 2006.

9% of homes on the market that were for sale by owner in 2014, unchanged from 2013.

18% homes on the market that were for sale by owner in 1997, a peak.

88% buyers financing their home purchase in 2014.

31 median age of first-time home buyers in 2014, unchanged from 2013.

54 typical age of home seller in 2014.

53 typical age of home seller in 2013.

17% of home owners in 2014 who wanted to sell their home earlier but were stalled because the home was worth less than the mortgage.

13% of home owners surveyed in 2013 who wanted to sell their home earlier but held off because their home was worth less than their mortgage.

increase in commercial property sales in Q3 2014 from Q3 2013.

National Association of Home Builders’ remodeling market index reading in Q3 2014, the sixth consecutive reading above 50, which suggests more remodelers report higher market activity than those reporting it lower.

57

7.4% Fannie Mae stock value on March 10, 2014, the highest since 2008.

$5.82

Fannie Mae stock value on Oct. 2, a one-year low.

$1.51

55.8 Architectural billings index tracking nonresidential construction activity in July 2014, the highest since July 2007 when it was 57.7.

A value above 50 indicates an increase in activity.




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Q&A: FTI CONSULTING’S WILLIAM ISAAC

Uncertainty about regulation has crimped hous-ing finance and other types of lending, which may be dampening the U.S. economy, William M. Isaac, senior managing director of FTI Consult-ing and former banking regulator, told Bloomberg Brief’s Aleksandrs Rozens.

Q: How do you feel about the latest turnaround since the credit crisis?A: It is really hard to generalize because real estate is for the most part local. I live in Sarasota and even within Sara-sota it is local by neighborhood. If you live on the water, you’re pretty good. If you live in other parts of town, things are not so good. A lot of the real estate that went through foreclosure has been purchased by investors, not by owners. You wonder how much of that really has been tucked away safely. If Blackstone or some other big firm comes in and buys a thousand houses, you can’t really be comforted because at some point those houses are going to come back into the market. They are not owner oc-cupied and somebody has invested in them hoping to flip them.

Q: What’s different this time?A: In the 1972 to 1974 period and in the 1980s, real estate hit a bottom. Banks and thrifts went out of business by the hun-dreds if not the thousands. The govern-ment took over their bad real estate and it was sold off at rock bottom prices. It had a good run following that. This time, I don’t think we had the clearing in the country that we had in those previous crises. We didn’t allow things to hit a bottom. We put a lot of pressure on banks to stop foreclosing and work out ways for people to stay in their homes. It may be why we haven’t seen prices come way up.

Q: What happens to Fannie and Freddie?A: In the Senate what they tried to do was to put them back in the marketplace and create an FDIC-like fund to cover extraor-dinary losses in the future. That didn’t go anywhere and likely won’t. Do you want to go ahead and nationalize them and make

Former Regulator Says Housing May Not Have Bottomed, New Rules Crimp Lending

Education: B.S. (Miami University, Oxford, Ohio, 1966), JD (College of

Law, The Ohio State University, Columbus, Ohio, 1969)

Career as regulator: FDIC Chief (1978-1985), chairman Federal Finan-

cial Institutions Examination Council (1983-1985), Member of Deposi-

tory Institutions Deregulation Committee (1981-1985), Member of Vice

President’s Task Group on Regulation of Financial Services (1984)

them publicly-owned entities or do you want to totally privatize them? Those seem to be the two major options. There seems to be a pretty strong agreement that you don’t want them to be a mixture. That got us into trouble last time. They were suppos-edly private entities with private ownership, with private sector type compensation, but everybody believed that they were backed by the government if they ever got in trouble. It wasn’t clear what they were. I

think we really need to be clear about that. Either they are private entities and ought to be run like private entities and capital-ized like private entities, or they ought to be public entities and we ought to not pretend they are private entities and their compen-sation packages ought to look more like public entities than private entities. They probably operate with a balance sheet that is not as strong as it would have to be if they were private entities.

Q: More people are priced out of loans because of how lenders underwrite mortgages. Is that in response to uncer-tainty in the regulatory environment?

A: Absolutely. You can price anything if you know what the terms are. There may be millions of people who got mortgages the last time around who aren’t going to get them this time.

Q: Ten years ago some 60 percent of all mortgage loans were underwritten by independent brokers. Now that lend-ing is consolidated with fewer lenders, what does that mean for housing?A: Banks have tightened their standards considerably and it is getting harder and harder for people in the low-to-middle-income category to qualify for credit, whether it is for a home loan or a car loan or an installment loan. It is getting harder and harder to get access to credit. Banks are de-risking, which basically means dumping customers. They are not dealing with people who really need credit. That’s a drag on the economy. It’s one of the things that’s keeping the economy from recovering and it’s due to a lot of factors. One of them is we have increased capital requirements in banks and liquidity re-quirements in banks significantly higher.

Q: Why are lenders doing this?A: Banks are saying we have to be a lot more selective about our customers. We only have so much capital we can devote to this business under the new guidelines, so let’s start dealing with customers where we have less risk of loss. That tends to be the upper echelon of potential borrowers that get the money. Roughly 71 million people in this country, or over 25 percent of the adult population — this is an FDIC study — are either totally unbanked or underbanked. They don’t have adequate access to the banking system.

“Banks are de-risking which basically means dumping customers. They are not dealing with people who

really need credit.”



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The U.S. housing crisis saw millions lose their status as homeowners. We estimate that nearly 17 percent of all homeowners with a mortgage in 2006 fell into either foreclosure or short sale. Although the foreclosure pipeline has declined consid-erably, there are still a number of seriously delinquent mortgages, suggesting further liquidations to come.

The path of these households after fore-closure or short sale and their decisions in coming years are important for under-standing the trend in homeownership and home sales. The majority of former owner-occupiers became renters. However, some also doubled-up with other households for a time, given the weakness in the econ-omy. We have seen a net creation of 6.5 million renters from 2007 at the expense of 2.3 million owners. Another way to think about it is that the homeownership rate has tumbled to 64.3 percent while the rental rate, which is the mirror image, has increased to 35.7 percent.

Are these households stuck as renters or will they attempt to enter the owner-ship market once again? On the one hand, these were previous homeowners, meaning they may have a proclivity for ownership once the scars from the crisis heal. However, they have witnessed a sharp decline in home values, which may have prompted them to rethink the risks of homeownership. The truth is that, in many cases, these households may not have the choice.

When borrowers go through foreclosure or a short sale, their credit is impaired. There are strict rules for receiving financing after credit impairment, otherwise known as being a “boomerang borrower.” To qualify for a conforming mortgage after a short sale, borrowers must wait two years with a 20 percent down-payment, four years with 10 percent and seven years with 5 percent. Borrowers who went through the foreclosure process typically must wait seven years. There are circumstances where the timeline is quicker, such as in event of divorce or the loss of a spouse.

According to research by Experian, there have been few boomerang borrowers thus far. For the 5.43 million properties that went through foreclosure in its sample, only 2.1 percent of the borrowers, or 114,100

Not Much Boom in Boomerang Borrowers

HOME OWNERSHIP MICHELLE MEYER, SENIOR U.S. ECONOMIST, BANK OF AMERICA MERRILL LYNCH

0.3%

0.5%

0.8%

1.0%

1.3%

1.5%

0%

1%

2%

3%

4%

5%

6%

1995 1998 2001 2004 2007 2010 2013

Mortgage Payments Past Due 90+ days (Left Axis)

Mortgage Foreclosures Started (Right Axis)

Source: Mortgage Bankers Association, BAML

Delinquent Mortgage Levels Remained High

29

30

31

32

33

34

35

36

37

62

63

64

65

66

67

68

69

70

1980 1985 1990 1995 2000 2005 2010

Perc

ent

Perc

ent

Homeownership rate (Left Axis)

Rental rate (Right Axis)

Source: Census Bureau, BAML

Homeownership Fell to Near 20-Year Low as Rentals Jumped

households, had purchased a primary home by the end of last year. Of the nearly 800,000 short sales that Experian tracked, only 5.5 percent of borrowers (44,300) had returned to the ownership market.

Research from the Federal Reserve Bank of San Francisco suggests these numbers are likely to grow, but only modestly. The authors find that only 30 percent of bor-rowers who defaulted in 2001 had taken

out another mortgage within 10 years. And these borrowers experienced more than a 100-point increase in their FICO score, showing significant healing. Moreover, the study covers 2001, right before the hous-ing bubble when price appreciation was rapid and credit was easy. In the current environment with tight credit, the numbers of borrowers re-entering is likely to be significantly lower.



Q&A: JEFFERIES’S LISA PENDERGAST

CMBS issuance will be lower than expected in 2014 because more loans are being underwritten by participants who retain mortgages on balance sheets, according to Lisa Pendergast, head of CMBS risk and strategy at Jefferies Group LLC. She spoke to Bloomberg Brief’s Aleksandrs Rozens in an interview conducted in late October.

Q: What will U.S. CMBS issuance be this year?A: We’ll see somewhere between $95 and $100 billion. That’s been somewhat of a roller coaster projection. Initially at the outset of 2014 I thought we would see at least $100 billion. Supply truly dried up in the first half of the year. It really did not open up until the second quarter, early third quarter when you started to see all of the originators increase their volume and that translated into increased CMBS transactions. Lower rates are certainly going to entice a number of borrowers to refinance loans that are coming due in 2015, 2016 and 2017.

Q: What was behind the decline in sup-ply in the first half?A: Competition. The CMBS lenders were finding it difficult to source product. Early on in the year, life companies had lots of mon-ey to spend and they certainly did. In many cases, what many CMBS lenders realized they had to do to get that product was to cut their spreads. You saw pricing on loans re-ally improve over the course of the first half of the year. The agencies, the GSEs also saw a real dip in supply in the first half of the year. But they have really seen things pick up over the recent two months.

Q: Beyond life companies, who are the other big lenders?A: Banks have come up very strong. The regional banks are starting to see a nice pickup in origination volume.

Q: Are they keeping it all on their balance sheets?A: Life companies and banks keep it on their balance sheets. The GSEs generally securitize and obviously CMBS lenders do the same.

Lenders Keep Mortgages on Balance Sheets, Putting Limit on CMBS Supply

Career: Previously head of commercial mortgage-backed debt research

at RBS Capital Markets, CMBS research analyst at Prudential Securities.

Favorite pastime: Biking

Last book read: “Ava Gardner: The Secret Conversations” by Ava

Gardner and Peter Evans

Favorite charity: Alzheimer’s Association

Q: A lot more of the collateral in CMBS is actually agency collateral. Why?A: It is the multifamily business. It is the one really seeing a continued strong transaction volume at the property level. In multifamily, as opposed to other markets, borrowers are comfortable moving beyond core markets and the safety of those core markets. It opens up possibilities for loan originations to pick up, given secondary markets some of these multifamily inves-tors are now focused on.

Q: How does the gravitation towards renting affect this?A: Homeownership is now in the 64 and change area. It reached almost 69 percent at the peak of the single-family housing boon. We may be experiencing a singular shift back toward a lower homeownership rate. There are all sorts of drivers behind multi-family demand, including the millennials out there who are ready to leave the nest as the economy improves and move into rentals. You have baby boomers who are retiring and moving into urban areas where you are more likely to rent than own. You have huge immigration inflows that are a big driver of multifamily demand. Then there are those who cannot afford to buy a home.

Q: More of the debt resold into CMBS is in the form of IOs or partial IOs. What’s your take on leverage?A: The life companies have become mildly more aggressive but they have not really left their comfort zone. In the CMBS market I do think that leverage is approaching levels we saw in 2007. The difference is, gener-ally speaking, the leverage is much more grounded than it was back then. Underwrit-ing is a lot more conservative, even though leverage points are starting to creep up and that has directly to do with heightened competition for loans.

Q: What is your outlook for CMBS spreads?A: You are going to see guys less afraid of duration given the rate environment. The AAA 10-year has gotten as tight as 74. We currently have it around 88. So, you could see spreads tighten into that level. There are investors that are pushing back from some of these credits. Some deals will price in the 90s and other deals will price in the mid 80s. The market is being selective where it can. On better deals we could go back to tights of the year in the mid 70s on the 10-year. On the BBB- we are at sort of an average of 345. The tight has been 290 so its possible we get to the low 300 area, but it really depends on a variety of things. Life companies either need to either change their bogey of around 4 percent or they are out. You have a 10-year swap rate in the 240 area and then you add 90 to that and you are at 330. You are way off from that 4 percent. They have other places to put cash and that may be where they focus.

“In the CMBS market, leverage is approaching levels

we saw in 2007.”



MORTGAGE CREDIT STANDARDS TOM SEIDENSTEIN AND STEVE DEGGENDORF, FANNIE MAE

Larger Lenders Expect to Ease Mortgage Credit Standards as Demand WeakensMany commentators cite tightened mort-

gage credit standards as a reason behind the slow pace of the economic and housing recovery. This naturally raises the question of when and if credit standards will loosen.

Fannie Mae’s Third Quarter 2014 Mort-gage Lender Sentiment Survey (MLSS), conducted during August, finds that credit conditions may already be evolving. Survey results show a higher proportion of larger lenders have eased than have tightened single-family credit standards in 2014. This is occurring against a backdrop of anticipat-ed tepid demand, with lenders of all sizes reporting expectations have slipped for single-family purchase mortgage demand during the next three months.

Among larger lenders surveyed, more report easing than tightening of credit stan-dards across all loan types (GSE eligible, non-GSE eligible and government loans). This easing tendency of larger lenders during the past three quarters is not yet so evident among mid-sized and smaller lenders. As an illustration, for non-GSE (government-sponsored enterprises — in this context, Fannie Mae and Freddie Mac) eligible loans, 33 percent of responding larger lenders say they have eased credit standards, compared with 13 percent who say they have tightened.

A greater share of larger lenders also ex-pect to ease than to tighten credit standards over the next three months. Increased competition was cited as the most common reason for easing lending standards.

With the housing market recovery quite gradual, lenders face a more competitive market for loan volume. In August 2014, Fannie Mae’s Economic and Strategic Re-search Group released an in-depth special topic analysis from its second quarter 2014 MLSS, which shows that larger lenders are more likely than mid-sized and smaller lenders to pursue non-QM (Qualified Mortgage) loans. Our third quarter 2014 MLSS suggests that some larger lenders may be tapping into the Non-GSE eligible and government loan market to offset their expectations for lower consumer demand in the last months of this year.

In the third quarter 2014 MLSS, many more lenders said consumer purchase

mortgage demand was up rather than

down for the prior three months. However, the share of lenders who expect purchase mortgage demand to go up over the next three months decreased significantly quar-ter to quarter, with the largest share decline of this opinion at 33 percentage points for GSE eligible loans.

Overall, lenders’ diminished sentiment

about the housing market is broadly in line with Fannie Mae’s Economic and Strategic Research Group’s 2015 housing forecast.

(Tom Seidenstein, vice president, and Steve Deggendorf, director, are with Fannie Mae’s Economic and Strategic Research Group. Views expressed are their own and figures are the responsibility of the authors)

25% 25%

33%

51%

63%

54%

24%

11% 13%

Q1 Q2 Q3Eased Remained Unchanged Tightened

Source: Fannie Mae

Larger Institutions Mid-Sized Institutions Smaller Institutions

13% 16%

23%

47% 53%

64%

41% 30%

13%

Q1 Q2 Q3

3% 16%

19%

60% 64%

53%

37% 21%

27%

Q1 Q2 Q3

Credit Standards Direction, Non GSE-Eligible Loans by Volume

59% 54%

21%

35%

43%

66%

6% 4%

13%

Q1 Q2 Q3

Go up Stay the same Go down

Source: Fannie Mae

52% 53%

27%

44%

42%

61%

4% 5%

12%

Q1 Q2 Q3

51%

42%

16%

42%

50%

67%

7% 7%

17%

Q1 Q2 Q3

GSE Eligible Loans Non-GSE Eligible Loans Government Loans

Purchase Mortgage Consumer Demand by Share of Institutions




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With the publica-tion of its “policy normalization” principles along-side its September FOMC statement, the Fed made clear its intention to wind down its portfolio of mortgage-backed

securities (MBS), through a multi-year, passive process that will begin no sooner than the Fed’s rate hikes.

A reasonable question to ask is: without the Fed’s activity in the MBS market, where will mortgage rates go, especially as the GSEs’ portfolios continue to wind down? Not far, as the decrease in quasi-governmental support will be outweighed by a decline in MBS issuance and de-mand from other fixed income investors.

We can break the mortgage rate into two or three components: the underlying risk-free Treasury rate, the spread of MBS rate (the “secondary rate”) over Treasury yields and the spread of the “primary” mortgage that consumers face over the MBS rate. The outlook for the first component, the level of long-term Treasury yields, has undergone a dramatic reversal this year, from a mantra that “rates must rise” as the Fed begins tightening to a growing conviction that Treasury yields will remain suppressed for some time by shifts in sup-ply as well as regulatory and geopolitical factors.

As for the second component, the spread between mortgage rates and Trea-sury yields, a quick review of the funda-mentals makes a strong case that this will remain tight over the medium term. Most important are the supply dynamics. The aggregate net issuance of agency MBS is likely to remain modest.

As of June, the Mortgage Bankers Association projected total mortgage originations for 2014 at $1.02 trillion — a 42 percent decrease from 2013 and the lowest annual total for mortgage origina-tions since 1997.

Moreover, mortgage growth is expected to be tepid for the foreseeable future, in light of concerns about slower house-hold formation, shifting attitudes towards

Mortgage Rates Can Ride Out Fed, GSE Portfolio Contraction

FED IMPACT ON MORTGAGES JOSH WRIGHT, BLOOMBERG ECONOMIST

Primary-Secondary Mortgage Spread Begins to Narrow

0

10

20

30

40

50

60

70

80

90

0.0

0.5

1.0

1.5

2.0

2.5

1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Mortgage Basis (Right Axis)Primary-Secondary Spread (Right Axis)Swaption-Implied Volatility (3m-10yr) (Left Axis)

Source: Bloomberg, Freddie Mac

Perc

ent Basis Points

homeownership, lingering weakness in existing household balance sheets and higher millennial student debt loads.

Already relegated by Treasuries to the second-largest fixed-income market in the world, agency MBS are unlikely to regain the lead for the foreseeable future.

The demand side also looks set to sup-port agency MBS spreads. The Fed is ex-pected to wind down its portfolio of MBS very gradually, over the course of about five years, starting about a year from now (once the Fed begins raising rates). That would imply net paydowns – that is a net increase in the tradeable float of agency MBS – of perhaps $10 billion a month to $20 billion a month from mid- to late-2015 until about 2020. In the meantime, the Fed’s unhedged holdings will continue to absorb not only duration but negative con-vexity from the market, depressing implied volatility and therefore MBS spreads.

Concurrently, the GSEs’ portfolios are scheduled to contract from a combined $873 billion as of the second quarter to a maximum combined $500 billion by the end of 2018.

That would imply only roughly $7.5 billion a month, and those paydowns will not have the same duration and convexity impacts as the Fed’s paydowns, since the

GSEs actively hedge their portfolios. Also, their net decline of $373 billion is about half as small as the $719 billion that the GSEs’ portfolios have already contracted since their peak at the end of 2008.

Meanwhile, numerous forces are align-ing to replace the lost demand from the Fed and the GSEs.

In developed economies, new capital and liquidity regulations will support banks’ demand for agency MBS and retiring Baby Boomers are shifting their investment portfolios to fixed income. From emerg-ing markets, East Asian sovereign wealth funds and a growing global middle class will continue to seek high-quality assets. With Treasury issuance set to decline in the short-term, that will only increase demand for Treasury-like securities.

As for the third component, the so-called primary-secondary spread between mort-gage rates and MBS yields, this has been pushed wider in recent years by a host of structural shifts in the mortgage origina-tion and servicing business.

These include changing regulations and higher risks of litigation or credit losses associated with GSE putbacks. As the le-gal environment stabilizes and the GSEs recalibrate their policies, this spread should stabilize, if not retrace.



MORTGAGE TRENDS

3.80

3.90

4.00

4.10

4.20

4.30

4.40

4.50

4.60

4.70

4.80

1,200

1,300

1,400

1,500

1,600

1,700

1,800

1,900

2,000

2,100

2,200

12/13 1/14 2/14 3/14 4/14 5/14 6/14 7/14

Perc

ent

MBA Refinance Index (Left Axis)

30-Year Mortgage Rate (Right Axis)

Source: Mortgage Bankers Association

Low Mortgage Rates Fail to Stir Up Massive Refinance Wave

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2000 2002 2004 2006 2008 2010 2012 2014

Partial IO IO Balloon Fully Amort

Source: Bloomberg LP *Transactions completed as of August 2014

*

CMBS Loan Leverage Little Changed From 2013 Levels

Requests for Loan Refinancings Decline Even as Borrowing Costs Skirt Historic Lows

Requests for home loan refinancings have drifted lower this year, damping a key source of profit for many lenders.

The Mortgage Bankers Association’s measure of requests for home loan refinancings, its refinancing index, was at a reading of 1,693.2 in late January. The refinancing index fell to a reading of 1,377 in late August.

Mortgage rates have generally been below 4.5 percent in 2014, failing to bring about a dramatic increase in requests for loans refinancings among home owners. The most notable jump in refinancings in the first three quarters of 2015 was evident in June a week after 30-year mortgage rates hit 4.26 percent; applications for home loan refinancings jumped and the refinancing index rose to 1,528.9.

Mortgages for U.S. commercial proper-ties that allowed borrowers to pay only interest or had partial-IO characteristics accounted for just over half of all debt resold into CMBS in 2014.

That is little changed from 2013 and suggests that lenders are increasingly hungry to put money to work in a low interest rate environment. The heightened use of IO loans comes as more lenders like insurance companies underwrite loans and keep them on their own bal-ance sheets as opposed to resell them as securities.

The use of IO and partial-IO mortgages was at its highest level since 2007 when over 80 percent of commercial property loans fell into this category.

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HOME BUILDING DREW READING, BLOOMBERG INTELLIGENCE ANALYST

-20

-10

0

10

20

30

40

50

60

70

80

2007 2008 2009 2010 2011 2012 2013 2014

Inde

x Le

vel

SDRMTGTP Index

Source: Federal Reserve, Loan Officer Survey

Banks Tightening

Banks Loosening

More Loan Officers Still Loosening Than Tightening: Survey

0 20 40 60 80 100

TRI Pointe HomesMeritage HomesTaylor Morrison

PulteStandard Pacific

RylandHovnanian

William Lyon HomesLennar

M/I HomesD.R. Horton

MDCKB Homes

LGI Homes

Percent First-Time Buyers Source: Company Filings, Bloomberg Intelligence

LGI Sells 100% of Homes to First-Time Buyers

Banks Remain Reluctant to Relax Mortgage Lending

While lax lending standards were a key catalyst to the collapse of the U.S. housing market, the pendulum may have swung too far in the opposite direction, leaving many would-be homebuyers unable to qualify for mortgage financing.

Banks have been reluctant to offer loans due to repurchase risk, in which banks must buy back bad loans. There have been only modest signs of more relaxed lend-ing among U.S. banks to date, the Federal Reserve’s Loan Officer Survey Shows.

The long-awaited Qualified Residential Mortgage Rule finalized last month did not include a disputed provision requiring banks to hold risk for mortgages without a 20 per-cent down payment. The rule is expected to draw more private capital into the residen-tial mortgage market.

Builders Get Boost Amid Looser Credit, Particularly for Entry-Level Buyers

U.S. homebuilders may benefit from recent policy moves aimed at expanding mortgage credit availability.

Strict lending standards have been one of the primary impediments to a more robust housing recovery. In particular, new guidelines may support greater lending to first-time homebuyers, who have been noticeably absent from the market.

Greater clarity may be coming at just the right time as the homebuilding spring sell-ing season is approaching.

LGI Homes reports approximately 100 percent of its sales are to first-timed home buyers.



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The recent rebound in home prices and Fed tapering have led many to question if home prices are vulnerable to a decline.

The Housing Affordability Composite Index from the National Association of Realtors shows that affordability was low in the 1980s until real estate prices dropped between 1989 and 1993. For most of the next 10 years, affordability remained stable with the index in a 125-145 range.

From 2003 to 2007, affordability dropped with a run up in real estate prices. A subse-quent collapse in home prices and drop in interest rates led to unprecedented levels of affordability, which peaked in early 2012.

After a rebound over the next two years, affordability has not yet returned to the 125-145 range, suggesting that there may be more upside depending on median household incomes and interest rates.

The index tracks the affordability of housing, typically based on a mix of median home prices, median income and mortgage rates.

HOME PRICES MICHAEL MORRISSEY, CFA, BLOOMBERG APPLICATION SPECIALIST

100

120

140

160

180

200

220

1986 1989 1992 1994 1997 2000 2003 2006 2009 2012

Hous

ing

Affo

rdab

ility

Inde

x

Source: National Association of Realtors

Home Prices May Rise More as Affordability Still High

100

120

140

160

180

200

220

2000 2002 2004 2006 2008 2010 2012 2014

Inde

x le

vel

Normalized CPIS&P/Case-Shiller home price indexCompound normalized CPI

Source: Bloomberg LP

Case-Shiller Outpaced Inflation Before CrisisAnother way to look at home prices is

to compare them to inflation. Over the long term, home prices typically rise by 2 percent over CPI annually.

Normalized CPI as measured by the Bureau of Labor Statistics has moved to 140 from 100 since January 2000. Adding 2 percent per year to the CPI would lead to a level of 180.

Overlaying the S&P Case Shiller 20 Home Price Index shows home price in-creases clearly outpaced inflation and the long-term rate (2 percent over CPI) before the market repriced from 2007-2009.

What is also notable is that the Case Shiller Index bounced off CPI before head-ing higher.

Assuming 2 percent a year increases in CPI, home prices may have some upside relative to inflation. Changing the assumption to 1.5 percent annual rises, home prices are at fair value.



MBS TRENDS MICHAEL MORRISSEY, CFA, BLOOMBERG APPLICATION SPECIALIST

Low mortgage rates have helped the housing market recover. The most com-mon measure of broad MBS value is the mortgage basis, the difference between current coupon yields and a risk-free benchmark.

The risk-free rate is derived from blended swap rates on the five- and 10-year to match duration of Fannie Mae 30-year pools.

Fed MBS purchases have kept spreads tight and pushed down the current coupon yield.

The mortgage basis, at 90 basis points over swaps, is approximately 40 basis points tighter than its widest level at the end of 2013.

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Oct-13 Dec-13 Feb-14 Apr-14 Jun-14 Aug-14

Perc

ent

Perc

ent

Current Coupon (Left Axis)5/10 Swaps (Left Axis)Mortgage Basis (Right Axis)


MBS Trading About 40 Basis Points Tight to 2013 Peak

0.6

0.8

1.0

1.2

1.4

1.6

1.8

Nov-09 Nov-10 Nov-11 Nov-12 Nov-13 Nov-14

Mor

tgag

e ba

sis (b

p)


5-year average

MBS Spreads Rich to Swaps Compared to Five-Year AverageLooking at the same spread over the last

five years would suggest that MBS is rich relative to swaps.

Spreads are unusually tight due to a limited supply of mortgage origination and strong demand from the Fed through the QE programs.

The tightening of spreads in 2012 was a direct result of people trying to get in front of the Fed purchases of QE3.

There is potential for spreads widening if the Fed changes course too quickly.

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The amount of agency debt resold into commercial mortgage-backed securities (CMBS) fell in the second quarter from the first quarter, reflecting a pickup in private label financing of multifamily properties.

The amount of conduit debt resold into securities fell in the second quarter to $11.48 billion, a low not seen since the fourth quarter of 2012, according to data compiled by Bloomberg.

Use of large loan flaters fell to the lowest since the third quarter of 2013.

In the second quarter, $12.08 billion worth of agency collateral was repack-aged into commercial mortgage bonds, down from $12.83 billion in the first quar-ter and from $19.26 billion in the year-ago quarter.

0

5

10

15

20

25

30

35

40

45

2012(Q1)

2012(Q2)

2012(Q3)

2012(Q4)

2013(Q1)

2013(Q2)

2013(Q3)

2013(Q4)

2014(Q1)

2014(Q2)

Hist

oric

al Is

suan

ce V

olum

e ($

Bill

ions

) European Large loan floaters Conduit Agency


Agency Collateral Use Declines in Q2 From Q1, Year-Ago Levels

CMBS YIELD PREMIUMS, COLLATERAL

Spreads of AAA-rated and BBB-rated bonds backed by commercial real estate property loans narrowed from the same period last year because of a pickup in demand by investors seeking extra yield.

In June, AAA-rated CMBS were at 52 basis points over swaps, in from 58.5 basis points in March and 80 basis points in the second quarter of 2013.

BBB-rated CMBS were at 205 basis points over swaps, in from 223 basis points in March and 450 basis points in the second quarter of 2013.

0

100

200

300

400

500

600

2/1/2013 5/1/2013 8/1/2013 11/1/2013 2/1/2014 5/1/2014

Spre

ads V

ersu

s Sw

aps (

Basi

s Poi

nts)

BBB-rated CMBS* AAA-rated 5 Year CMBS*

Source: Commercial Real Estate Direct - crenews.com

(* CMBS 2.0 and 3.0 Spreads)

U.S. AAA and BBB Rated CMBS Spreads Narrow in Q2

COMPARE LOAN YIELDS FROM YOUR SCRAPED MESSAGES



0

5

10

15

20

25

30

1/2013 5/2013 9/2013 1/2014 5/2014

Issu

ance

($Bi

llion

s)

All US ($Bln) All Non-US ($Bln)


CMBS Issuance Rose From May to June; Q2 Supply Off Year-on-YearIssuance of bonds backed by com-

mercial real estate debt in the U.S. rose to $15.4 billion in June from May’s $12.6 billion and April’s $5.9 billion.

A year ago, $9.99 billion worth of U.S. commercial mortgage bonds was sold in June.

Second quarter U.S. commercial mort-gage backed security issuance totaled $33.9 billion, down from $36.6 billion in the first quarter.

In the second quarter of 2013, U.S. CMBS issuance totaled $40.34 billion.

CMBS ISSUANCE

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