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MBS/CMBS Commentary

Euclid Financial Group Mortgage Commentary 08/27/2007

By Andreas Pericli, Ph.D. and Andreas Christofi, Ph.D.

Economic Outlook & Mortgage Performance

With financial markets in turmoil, worries about the health of the US and global economies are mounting. Currently, the most frequently asked question that market participants and analysts ask is "whether the US economy will enter into a recession in 2008." Our quick answer is that the odds are still very small, although, we agree with the recent assessment of the Federal Open Market Committee (FOMC) on August 17, that the most recent liquidity crisis has increased appreciably the risks to growth. What started earlier in the year as a concern about the performance of subprime mortgages and securities backed by subprime mortgages has recently evolved to concerns about credit risk in all types of credit markets that include relatively safe markets such as the commercial paper market. These concerns have caused significant re-pricings of credit risk which resulted in significantly higher borrowing costs for corporations and individuals. In our view, this re-pricing of credit risk in conjunction with the significant tightening of underwriting standards for residential loans increased the likelihood that the housing recession will be more severe than we previously forecasted.

Put simply, this credit risk re-pricing has created significant volatility in both the equity and the credit markets and increased the fears that the US economy particularly and perhaps the global economy will enter into a recession in 2008. The Fed has responded with specific actions to this rise in uncertainty that aimed to restore the lack of liquidity in the credit markets. In particular the Fed has responded to this liquidity crisis by: 1) injecting reserves (liquidity) via the repo system; and 2) by lowering the discount rate from 6.25% to 5.75% (which is another way of addressing short-term liquidity problems). In addition, the Fed, with a statement, has reaffirmed the markets that it is monitoring financial conditions and it will take additional steps if needed to restore liquidity in the short-term credit market.

While it may be little bit to early to celebrate, these actions to restore liquidity in the financial system have shown some encouraging results in the last week. Consequently, the "effective" prime rate (a counterpart to the "official" prime rate) is now lower by at least a quarter of a percent. At this time, we expect that the Fed will not take any additional action before the next FOMC meeting which is scheduled on September 18. By September 18, we believe that, the Fed will be in a better position to evaluate the possible effects of this liquidity crisis on growth and inflation. In our view, the Fed has taken the best steps possible in restoring market liquidity while it continues to monitor the financial markets and it tries to re-assess its growth and inflation outlook.

In putting things into a historical context, on August 3, the FOMC assessed that the US economy will grow at around 2.25% in the second half of the year and then accelerate to near trend growth (2.25% to 2.75%) in 2008. In addition, the committee also stated that inflation and not growth was its primary concern. However, on the most recent statement the committee stated that the most recent credit episode increased risks to growth appreciable.

We believe that the recent developments in the credit and equity markets cannot be ignored and we continue to expect that they will not go away any time soon. Although equity markets recovered part of their losses (in the last few trading sessions) and they are still up year today, a significant drop (from the current levels) in the equity markets and a significantly worse than expected housing recession can eventually affect consumer psychology and ultimately consumer spending. However, even with worse than previously expected housing recession, if the liquidity crisis materially improves over the next month (which we feel is highly possible, given the recent FOMC actions), we still feel that the odds that the US economy will go into a recession are still very low. The recent drop in oil prices and the softening of the US dollar are offsetting partly the increase in borrowing costs and the decline in equity valuations. In addition, we still expect that unemployment levels will increase gradually and not abruptly. We still see strong business balance sheets and, assuming that financial liquidity gradually restores over the next couple of months, we expect the global economy including the European and Asian economies will remain healthy and strong enough to withstand the effect of the worse than expected US housing recession. Other good news, include the fact that US export growth does not seem to be at risk yet, as long as the global economy remains healthy.

The yield curve (measured by the difference between the 10-year and the 2-year Treasury note) has flattened materially in the last 3 trading sessions. In particular, the yield curve flattened by 22 basis points (bps) between the close of August 21 and August 24 and is almost unchanged between August 24 and July 31. In particular, the 2-year Constant Maturity Treasury rate increased by 25 bps to 4.30% between August 21 and August 24, while the 10-year Treasury rate increased by only 3 bps to 4.63% in the same time period.

The risks to our economic outlook include: a prolonged period of credit liquidity; the chance of a sustained and prolonged equity correction; increases in oil prices given the geopolitical and middle-east risks; a significantly worse than expected slowdown in the housing markets; a substantial instant cutback in consumer spending; a possible slowdown in the Eurozone and the Asian markets, as a result of the credit crunch; and the risk of a significant terrorist attack.

Agency mortgage backed securities are the less affected by credit liquidity while prime non-agency pass-throughs, Agency and non-Agency hybrids and fixed-rate IOs are all currently priced at levels that are offering significant concessions for liquidity. For example, fixed-rate IOs and 10/1 hybrids, offer liquidity concessions of a half a point to a point, while non-Agency fixed-rate IOs and 10/1 hybrids offer liquidity concessions between 1 and 2 points.

July Prepayments

Aggregate 30-year and 15-year conventional prepayment speeds in July (released in August) declined as compared to June. Boosted by repurchase of delinquency loans as a result of change in servicing guidelines, FNMA premium speeds slowed by only 2.2%, while FHLMC speeds dropped by 15%. In particular, aggregate speeds of FNMA 30-year MBS printed 9.7% one-month Constant Prepayment Rate (CPR), down 1.2% CPR from June, while aggregate speeds on 30-year FHLMC securities declined from 10.3% to 9.3% CPR in the same time period. Overall, prepayments of 15-year FNMA and FHLMC securities declined by about 7.0%, slightly less than the decline in the 30-year prepayments.

Short-Term Prepayment Outlook

The MBA seasonally adjusted refinance index came in at 1,875 for the week ending 8/22/2007, down 6.4% from the previous week. The MBA seasonally adjusted purchase index declined by 5% to 427. The combination of the slowing housing markets and tight underwriting standards will force long term premium and discount speeds to decline significantly. We expect August speeds to be flat to marginally up, as compared to the July levels, despite the 2-day increase in the business calendar.

Closing Remarks

It is our goal in writing this article to provide readers with a concise summary of the major issues driving the mortgage markets sprinkled with a bit of commentary. Feel free to contact us to discuss any points on this commentary or the market in general (address to: Thank you for reading.

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