Mortgage-backed securities (MBS) are the starting point for all mortgage market pricing and the investment of choice for mortgage REITs
When the Federal Reserve talks about buying mortgage-backed securities, it’s 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’re looking at the Ginnie Mae 3.5% coupon for July. For those who have been following this series, if rates stay here next week, the 4% coupon will become the benchmark.
Loan originators base loan prices on the TBA market. When they offer you a loan (as a borrower), your rate is par, give or take any points you’re paying. Your originator will then sell your loan into a TBA. If you’re quoted a 4% mortgage rate with no points, the lender will fund your loan and then sell it for the current TBA price. In this case, the TBA closed at 101 3/32, which means your lender will make just about 1% before taking into account the lender’s cost of making the loan. This means a borrower will have to pay a lot of points to get the 3.75%-to-4.125% rate.
The Fed is the biggest buyer of TBA paper. Other buyers include 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 of their trading is done “on the wire” or over the phone.
FOMC meeting confirmed the market’s worst fears
Last week, the Fed confirmed that the default path for quantitative easing is to slow down purchases sometime this year, with a probable end to the practice in mid 2014. Before the meeting, the market discounted the likelihood of continuing asset purchases by default and withdrawing if we get strong economic data. That probability has now been reduced to zero.
The Fed is confident that the increase in rates will not negatively affect the economy. While mortgage rates are still low by historical standards, the move over the past two months has been breathtaking.
Implications for mortgage REITs
Mortgage REITs such as Annaly (NLY), American Capital (AGNC), MFA Financial (MFA), Capstead Mortgage (CMO), and Hatteras Financial (HTS) will suffer mark-to-market hits on their portfolios of mortgage-backed securities. For any bond, 3 1/2 points in one week is a big move. For highly levered REITs, this move is exceptionally painful.
As a general rule, a lack of volatility is good for mortgage REITs because they hedge some of their interest rate risk. Increasing volatility in interest rates increases the cost of hedging. This is because as interest rates rise, the expected maturity of the bond increases, as there will be fewer prepayments. On the other hand, if interest rates fall, the maturity shortens due to higher prepayment risks. Mechanically, this means mortgage REITs 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 it explains why Ginnie Mae MBS yield so much more than Treasuries that have identical credit risk (which is to say none).
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