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Ginnie Mae Mortgage Backed Securities continue to sell off

Ginnie Mae TBAEnlarge GraphMortgage backed securities are the starting point for all mortgage market pricing, and are the investment of choice for mortgage REITs

When the Federal Reserve talks about buying mortgage backed securities, it is referring to the To-Be-Announced (TBA) market. The TBA market allows loan originators to take individual loans and turn them into a homogeneous product that can be traded. TBAs settle once a month, and government mortgages (primarily FHA/VA loans) are put into Ginnie Mae securities. TBAs are broken out by coupon rate and settlement date. In the chart above, we are looking at the Ginnie Mae 3% coupon for June.

The TBA market is the basis for which your loan originator prices a loan. When they make a loan to you (as a borrower) your rate is par, give or take any points you are paying. Your originator will then sell it into a TBA. If you are quoted a 3.5% mortgage rate with no points, the lender will fund your loan and then sell it for whatever the current TBA price is. In this case, the TBA closed at 103 2/32, which means your lender will make just about 3 percent before taking into account their cost of making the loan.

The Fed is the biggest buyer of TBA paper. Other buyers are sovereign wealth funds, countries that have trade surpluses with the U.S., and pension funds. TBAs are a completely “upstairs” market in that they don’t trade on an exchange and most trading is done “on the wire” or over the phone.

Mortgage backed securities could simply be the victim of the “risk on” trade

The bond market sell-off continued for another week as investors continue to pile into equities. The economic data last week was generally mixed-to-negative, and should have been bond bullish. The big mover of rates last week was the FOMC statement and Ben Bernake’s testimony in front of Congress. When pressed about when the Fed plans to end QE, Bernake refused to rule out ending QE this Fall. The bond market sold off dramatically on his comments.

Implications for mortgage REITs

Mortgage REITs, such as Annaly (NLY), Capstead Mortgage (CMO), and Hatteras Financial (HTS), are the biggest beneficiaries of quantitative easing, as it helps keep their cost of funds low and they benefit from mark-to-market gains. This means that their existing holdings of mortgage backed securities are worth more as the TBA market rises. The downside is that interest margins compress going forward as yield moves inversely with price. Also, as mortgage backed securities rally, prepayments are likely to increase, which negatively affects mortgage REITs.

As a general rule, a lack of volatility is good for mortgage REITs due to the fact that they hedge some of their interest rate risk. Increasing volatility in interest rates increases the cost of hedging. This is due to the fact that as interest rates rise, the expected maturity of the bond increases as there will be less prepayments. On the other hand, if interest rates fall, the maturity shortens due to higher prepayment risks. Mechanically, it means they must adjust their hedges and buy more protection when prices are high and sell more protection when prices are low. This “buy-high/sell low” effect is called “negative convexity” and explains why Ginnie Mae MBS yields so much more than Treasuries that have identical credit risk (i.e. none).