Must-read: Worst day for Fannie to-be-announced loans since sell-off began

Fannie Mae TBAEnlarge Graph
Mortgage-backed securities are the starting point for all mortgage market pricing, and they’re 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 market (usually referred to 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 Fannie Mae loans are put into Fannie Mae securities. TBAs are broken out by coupon rate and settlement date. In the chart above, we’re looking at the Fannie Mae 4% coupon for July. Followers of this weekly piece may notice the change in coupon. Because rates have risen, the current coupon Fannie Mae TBA is now 4%. Another day like Friday, and we’ll be best-exing into the 4.5s.

The TBA market is the basis for which your loan originator prices a loan. When the originator offers a loan to you (as a borrower), your rate is par, give or take any points you’re paying. Your originator will then sell the loan into a TBA. If you’re quoted a 4.5% 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 102 2/32, which means your lender will make close to 2% before taking into account the cost of making the loan.

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.

A thin market means moves are more volatile

The economic data last week were generally strong, but the jobs report really was the catalyst for the drop. While unemployment was steady at 7.6%, nearly 200,000 jobs were created in June, and the April and May totals were revised upward by 70,000. While rates are being driven by speculation about the Fed’s stance on ending quantitative easing, this is all in the context of a worldwide “risk on” trade. The jobs report came on a day where desks were undoubtedly under-staffed, and volumes were extremely light. Thin markets tend to be volatile markets, and that was probably a driver for the record drop of 1 3/4 points on Friday.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 is, difficult to sell without losses). That problem eased slightly 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 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.