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 (also know as the 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 4% coupon for August.
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 104 10/32, which means your lender will make just under 4.5% before taking into account their cost of making the loan. The borrower will probably have to kick in a point or two in order to lock in that rate.
The Fed is the biggest buyer of TBA paper. Other buyers include sovereign wealth funds, countries that have 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 of their trading is done “on the wire” or over the phone.
Fixed income instruments rebound after a sharp sell-off on thin volume
Mortgage-backed securities sold off particularly hard the week of July 4, as a stronger-than-expected jobs report fueled selling in a thin (low volume) market. Many participants had taken a four-day weekend, and it didn’t take much selling to push TBAs lower on little volume. Ben Bernanke’s Humphrey Hawkins testimony was relatively dovish (not very aggressive), which took some of the pressure off the TBA market. Last week, there was no market-moving economic data, so it seems like bonds have found a trading range of 2.48% to 2.58%. Ginnie Mae TBAs sold off as the ten-year bond yield hit the top of that trading range.
Implications for mortgage REITs
Mortgage REITs, such as Annaly (NLY), American Capital (AGNC), MFA Financial (MFA), Capstead Mortgage (CMO), and Hatteras Financial (HTS), are beginning to announce earnings. Last week, we heard from agency adjustable-rate mortgage REITs Hatteras and Capstead. Capstead has been invested in shorter-duration paper, which has helped it weather the storm better than Hatteras.
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 pre-payments. On the other hand, if interest rates fall, the maturity shortens due to higher pre-payment 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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