We wrap up the year with the S&P (a better broad measure of stock performance than the DOW) essentially flat on the year, but 10-yr yields nearly 1.5% lower than a year ago. For 2012 fixed-income traders seem focused on the U.S. election and continued bickering, more regulation in the U.S., Europe and its eventual endgame, where U.S. data shows the economy is headed, will the Middle East ever be stable, and what will happen to China. They are pretty much the same things as a year ago.

So where is the economy, and rates, going? Freddie Mac revealed its outlook, forecasting that U.S. economic growth would likely climb to 2.5 percent over 2012 and that mortgage rates would stay at record lows. "While the headwinds remain strong going into 2012, there are indications the economy and the housing market are gaining ground, albeit slowly," Frank Nothaft, VP and chief economist with Freddie, said in a statement. The company said that mortgage rates would stay low, with 4 percent for the 30-year fixed-rate mortgage leading the way recently. Nothaft forecasted that recent modifications to the Home Affordable Refinance Program would increase refinance originations by more than $100 billion over the next year, giving a lift to purchase-money biz but letting single-family originations enter a shortfall over the next year.

Another forecast noted, "We expect 2012 to be a fairly similar year to 2011 for the mortgage market. While we expect a decline in residential mortgage volume (forecast a moderate decline in mortgage origination volume in 2012 to $1.1 trillion from an estimated $1.2 trillion in 2011) as refinance activity tapers off, originations should get support from still low rates and implementation of HARP 2.0. The lower volumes will likely lead to weaker mortgage production margins. Mortgage credit is likely to remain stable although we expect increasing delinquency rates on FHA loans. We expect little mortgage market reform through Congress, but there could be some changes driven by the regulators such as the release of a definition of a Qualified Residential Mortgage (QRM) and the introduction of a GSE risk-sharing pilot program." So noted a research piece from Keefe, Bruyette & Woods, Inc.

Fannie Mae's chief economist, however, is warning that the United States has a 40% chance of slipping into a double-dip recession in 2012. Recently Doug Duncan predicted a 50% chance of a double-dip recession next year, due to persistently high unemployment and the ongoing housing slump. But an uptick in job growth and stronger automotive and retail sales forced Duncan to revise his dour forecast slightly upward. He does not anticipate the housing market to fully rebound before 2015. And he expects to see plenty of contagion from Europe. One of the major problems is the housing market, he says. In past downturns, home sales have led a recovery, but this time around low interest rates have not pulled mortgage lending or consumer sentiment out of the doldrums. Chronically high unemployment over the next decade and weak income growth will continue to expert pressure on housing prices, he says: "Until employment picks up, you won't see any improvement in housing." Check it out.

Rarely do forecasts come true 100% of the time, however, and there were some from last year that did not. There was no double-dip recession in 2011, and the year is ending on a positive note with the U.S. economy is growing at an estimated 3.5-4% annualized pace in the fourth quarter. The European currency union did not come apart in 2011, although it had a few near-death experiences requiring multiple summits. The 11 countries that hitched their wagon to the common currency in 1999 and the 6 that joined subsequently are still together. About a year ago banking analyst Meredith Whitney's forecast of a large number of municipal defaults failed to materialize, fortunately, with less than $2 billion going into default according to a report from Bank of America Merrill Lynch. In fact, the U.S. Census Bureau just reported that state and local
government tax collections rose 4.1 percent in the third quarter from a year earlier, the eighth consecutive increase.

But disaster is always on the minds of many, and the Federal Reserve issued proposals intended to prevent the collapse of major financial firms. "The proposal would create an integrated set of requirements that seeks to meaningfully reduce the probability of failure of systemically important companies and minimize damage to the financial system and the broader economy in the event such a company fails," a Fed statement said.

The Federal Reserve released a draft proposal that outlines a change to the liquidity capital ratio (LCR) tests that are included in the Basel III reforms. It is important to note that the treatment of conventional and Ginnie Mae MBS was only one small part of the Fed's proposal, titled "Enhanced Prudential Standards and Early Remediation Requirements for Covered Companies." Under the Fed's proposal, Fannie and Freddie securities would be classified as "highly liquid assets," the same liquidity treatment as Ginnie Maes. This makes agency MBS more appealing for purposes of attaining liquidity benchmarks. Remember that liquidity capital is not risk-based capital - the 20% risk-based capital weighting for Fannie and Freddie MBS is not going away, which means that the more restrictive capital requirements will remain untouched. For the purposes of risk-weighting, Ginnies are still classified as "Level 1" assets, while conventional MBS are labeled as "Level 2." The risk weighting assigned to any asset is determined by the Basel Committee for Banking Supervision - not the Federal Reserve. And overseas investors buy Ginnie MBS's for reasons that have little to do with the Basel III capital requirements. For these investors, the liquidity test is far less relevant than the presence of a full US government guarantee - something that is not going to change any time soon. All this is open to comments for the next three months.

One CEO wrote, "The Basel III regulations show that ultimately I don't think that the United States banks can say to the world that they don't have to follow the same rules as everyone else. They can't say, 'Hey world, don't worry about us and residential lending- we know what we are doing.' The main contention for the Clearing House around Basel III is that it caps tier 1 capital reserves for MSR at about 10% (if my research is correct). This means that a bank like Wells Fargo that has $125 billion in Tier 1 capital would be limited to $12.5 billion in MSR (mortgage servicing rights). Depending on where the MSR is marked (say 4x servicing values, for example, on a Fannie Mae MSR although I think the norm is about 86-100 bps right now), and assuming that the strip is .25%, then the total amount of servicing that Wells Fargo could hold would be somewhere in the neighborhood of $1.25 trillion. This has huge implications. Think about the fire sale of servicing or reduction in production by the larger banks that has to occur between now and 2018 (when Basel III is slated to go into effect). We are already seeing servicing values reflect this uncertainty."

He continues, "Does it matter that the large aggregators are going to be reducing their holdings of MSR due to Basel III? Why is this good or bad? It will allow free flow of capital from foreign markets because we are all on the same 'regulatory path'- something we will need for our recovery. This is also the intention behind Dodd Frank of course. It will allow the aging western civilization to match cash flows that suit their lifestyle with something other than treasuries and still have some relative notion of safety - even as credit widens because the concentrated risk in one institution would be much smaller. More players, in the mortgage lending part of banking, mean more competition. This drives cost to the consumer down and it also reduces systemic risk. The servicing value attributed to MSRs is in direct correlation to what a small aggregator can reasonably put on its books. Basically, if someone is out "buying the market" with higher servicing multiples, due to business a differing business strategy or overhead, then this would keep smaller servicers from being able to acquire the best quality loans at a reasonable price.

"But if banks need to make higher yields they are invariably going to chase higher risk assets to do so. The markets 'are what they are' and they will need to do this - they can't just inflate margins on commodities- it will only work in the short run. Too much regulation could lengthen the recession. It could stifle growth of our largest banks and this is not good for a large economy like ours- we need supersized banks to handle massive sized projects that we have in the United States- it's what makes our economy so incredible. Money center banks are important and we need them to stay relatively large." So wrote Matt Ostrander, CEO, Parkside Lending, at matt@parksidelending.com.

Turning to the markets, the National Association of Realtors (NAR) announced yesterday that pending home sales in November reached the highest levels seen in 19 months. Many view this number as a leading indicator of the level of sales over the next 30 to 90 days, and is based on signed contracts for home purchases and does not reflect transaction closings. Lawrence Yun, NAR chief economist, said the gains may result partially from delayed transactions - pent-up demand. But any LO will tell you that contract failures have been running unusually high, often due to mortgage approval or appraisal problems.

No one is complaining about mortgage rates, and volatility is pretty low heading into year-end. Yesterday the "benchmark" 10-yr T-note closed at 1.90%, but on the mortgage side MBS prices improved slightly on little supply and continued decent demand. (Remember overnight rates are set by the Fed, mortgage rates are set more by supply and demand.) There was a little news yesterday, but none today - even Europe has quieted down somewhat. The 10-yr is currently trading around 1.90% and agency MBS prices roughly unchanged in the early going prior to the early bond market close and Monday's holiday.

Dear God -
My prayer for 2012 is for a fat bank account & a thin body.

Please don't mix these up like you did last year.

If you're interested, visit my twice-a-month blog at the STRATMOR Group web site located at www.stratmorgroup.com. The current blog discusses the time frames for borrowers returning to A-paper status after a short sale or foreclosure. If you have both the time and inclination, make a comment on what I have written, or on other comments so that folks can learn what's going on out there from the other readers.