The Fed is the biggest buyer of TBA paper. Other buyers include sovereign wealth funds, countries with trade surpluses with the United States, 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.
MBS rally after a Friday sell-off on low volume
The week of July 4th, mortgage backed securities sold off heavily on the back of a stronger than expected jobs report. The selling may have been exaggerated by the fact that many traders took off the Friday after the 4th, so markets were thinner than normal. Since desks were fully staffed on Monday, TBAs opened up a point from the Friday close and never looked back. The FOMC minutes and dovish comments out of Ben Bernanke also helped support mortgage backed securities this week.
Implications for mortgage REITs
Mortgage REITs, such as Annaly (NLY), American Capital (AGNC), Capstead Mortgage (CMO), MFA Financial (MFA), and Hatteras Financial (HTS), are the biggest beneficiaries of quantitative easing, as quantitative easing helps keep REITs’ cost of funds low and they benefit from mark-to-market gains. This means their existing holdings of mortgage-backed securities are worth more as the TBA market rises. The downside is that interest margins compress going forward, because 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 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 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 it explains why Fannie Mae MBS yield so much more than Treasuries. While Fannie Mae mortgages do not have an explicit government guarantee, they are “government-sponsored” and considered to be guaranteed by the government. That said, Ginnies and Fannies do trade at a spread to each other, with Ginnies trading at a premium because of their explicit government guarantee.