<

Fannie Mae TBAs rally as REIT selling diminishes

Fannie 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 Fannie Mae loans are put into Fannie Mae securities. TBAs are broken out by coupon rate and settlement date. In the chart above, we are looking at the Fannie Mae 4% coupon for July. Followers of this weekly piece may notice the change in coupon. As rates have risen, the current coupon Fannie Mae TBA is now 4%.

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 4.5% 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 104 7/32, which means your lender will make close to 4 1/4 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 with 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 were buffeted by mortgage REIT selling

Bonds rallied last week as the market digested Ben Bernanke’s FOMC statement. The economic data last week was good as durable goods orders increased, as well as consumer confidence. It could be that U.S. treasuries are not being pushed around by the data and are simply victims of a worldwide “risk on” trade.

The amount of leverage used by mortgage REITs has caused them to de-lever in a difficult environment. Immediately after the FOMC meeting, mortgage REITs and mortgage originators found themselves on the same side of the boat, and the TBA market became somewhat illiquid. That problem eased somewhat last week. Overall, since the bond market began its sell-off, mortgage REITs have under-performed.

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 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 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 are 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.