Fannie Mae reported its January total serious delinquency rate for single-family houses: the rate hit a new record of 5.54%, a jump from the December's 5.38%, and double the 2.77% in January 2009. All in all a perfect time for the Fed to be moving away from the mortgage market, pardon, to no longer being the mortgage market. The one saving grace for the Fed, was that new issuance keeps declining: $43.9 billion in MBS was issued in February, 7% less than the $47.6 billion in January. Yet $44 billion is not zero, and we anticipate ongoing new issuance which will need to find private buyers now that taxpayers are out of the picture. And even as Fannie's total book of business grew at a 1% annualized pace to $3,229,645 MM, the actual guaranteed MBS and mortgage loans declined at 0.9% to $2,882,552.

Incidentally, it's worth nothing here that the Chief Fixed Income Strategist of MS Smith Barney Kevin Flanagan told Market News earlier that investors should reduce exposure to MBS, which he said are expensive even without considering that the Fed is no longer buying MBS. Flanagan said that "for those investors looking to buy agency MBS anyway, they are

better off avoiding the political uncertainty surrounding the future of Fannie Mae and Freddie Mac by sticking to the front end of the curve -- under the two-year area." Well, judging by the weak 4 week and 56 Day CMB auctions, this is certainly not happening at the ultra-short end of the curve.

While Flanagan recommends staying within the 2- to 5-year sector for Treasuries and even high yield, not only would he overweight investment grade corporates but he'd also go out the curve. Not too much, however, as Flanagan says he would not go beyond the 8-year sector. Overall, he said, the biggest risk in fixed income markets right now is interest rate risk, closely followed by sovereign risk.

Flanagan noted that "U.S. fundamentals are not too supportive, given the unsustainable fiscal deficits, higher debt burdens, record coupon supply this year and the economic recovery."

Going back to MBS:

"By any metric that you use when looking at MBS valuation they're expensive," Flanagan said.



And that's also without considering the Federal Reserve no longer buying agency MBS or questions about asset sales down the road.



"When you throw that into the mix," he said, "you could see how it could be a challenging environment for mortgage-backed over the next couple of quarters." Flanagan does not expect the so-called "cliff effect" when the Fed stops buying agency MBS, as some "natural buyers" such as banks might re-emerge.



That said, not only is he concerned about their valuation, but also about the impact of the rising Treasury yields on the MBS market, as he expects the 10-year Treasury yield to rise to at least 4.50% this year.

Fannie February Report