Todays market news

Mortgage rates are very near the year's lows, and the pace of mortgage origination is triple what it was two weeks ago.  Blame it on the spread between mortgage and Treasury yields; the spread dropped by 0.38% last Monday.  The drop made perfect sense, since the risk of default on Fannie/Freddie notes had been trading at - you guessed it - 0.38%.  Default insurance on Lehman's bonds traded at 20.00% on Friday, by the way.  You should have bought some.

Going forward, the spread between mortgage and Treasury yields will be driven more by traditional variables:  market volatility and the related movements in the swap spread (the "swap spread" is the difference between LIBOR and Treasury yields).  Swap spreads dropped by 0.10% on the previous weekend's Fannie/Freddie news - they have since widened by 0.20%.  LIBOR is trading slightly more than 1.00% over Treasury yields. 

Accordingly, mortgage-Treasury spreads are wider by 0.20% this morning.  Fortunately for our budding refinance boom, Treasury yields dropped by at least that much on news of Lehman's bankruptcy, Merrill's takeover, and AIG's capital crisis.   Mortgage lock volume is very strong.

The Fed is expected to cut rates again.  Friday, there was a very small probability of a near-term rate cut.  Not any more.  This morning, December fed-funds futures are trading at 1.73%, reflecting a 100% probability that the Fed will cut rates 0.25% by year-end.  There is a 10% chance they'll cut rates this week.

Relationships of all kinds changed last week.  Bankers have a steep yield curve to cheer once again.  The difference between two-year and ten-year Treasury yields stands at 1.69%, well above the 1.40% at which it has traded for months now.  Spreads between Ginnie Mae (truly the U.S. government) and Fannie Mae securities narrowed from 0.30% to 0.15% last week, to the level at which the spread traded for many years.  When or if the spread drops to zero, reflecting the government's explicit rather than implicit guarantee, is anyone's guess.  Overall mortgage production dropped 10% in August, and Ginnie Mae now makes up 40% of the total.  The yield on Agency debt, one of the primary beneficiaries of the Fannie/Freddie takeover, is trading well this morning.  Its relative yield dropped 0.30% last week; agency debt yields about 0.70% more than equivalent Treasury debt.

These are historic times on Wall Street.  The collapse of Drexel in 1991 seems small by comparison, as does the 1998 failure of the hedge fund Long Term Capital Management.  Merrill Lynch, the investment bank where I began my career, has taken more than $45 billion in write-downs, a figure that is twice the profit Merrill made in the two and a half years before the credit crisis.  The collapse of Lehman, a firm that survived countless financial crises in its 158-year history, is most dramatic.  "Everyone thought Bear Stearns was a bunch of cowboys; it made sense what happened," said an executive. "This is not supposed to happen to Lehman Brothers."  Of the top five independent investment banks - Bear, Lehman, Merrill, Goldman, and Morgan Stanley - only two survive. For the moment, we take some solace from the fact that we owe Lehman money (on short bond positions) and not the other way around.

Are you folks following this Freddie Mac/Fannie Mae fiasco? Earlier today, Freddie Mac and Fannie Mae were both adopted by Angelina Jolie. -- David Letterman