Implications for mortgage REITs
For mortgage REITs like Annaly (NLY), American Capital (AGNC), MFA Financial (MFA), and Hatteras (HTS) that invest heavily in agency paper, a post–Fan and Fred world will change the structure of their portfolios. For starters, the government is considering consolidating Fannie Mae and Freddie Mac mortgage-backed securities—even before making any decisions over the fate of Fannie and Fred. Freddie Mac securities generally trade at a discount to Fannie Mae securities given their higher prepayment assumptions. How would such a move affect existing Fannie Mae and Freddie Mac securities is anyone’s guess. TBA prices for Fannie and Freddie MBS would undoubtedly converge. This would probably mean that REITs will want to favor Freddie Mac paper over Fannie Mae paper and play the convergence trade.
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A second change is that Ginnie Mae I and Ginnie Mae II mortgage-backed securities will probably merge. Ginnie I securities have one coupon rate, while Ginnie II securities have a blended rate that could have a wider range. As a result, Ginnie II securities have typically traded behind Ginnie I securities. At the present time, Ginnie IIs are actually trading ahead of Ginnie Is—although that could be due to REIT de-leveraging. Ginnie Is are more liquid than IIs, so REITs tend to prefer them. As REITs unload paper, there’s more selling pressure on the Is, which means they’re trading at a slight discount.
The bigger question is, what will happen to the liquidity of existing mortgage-backed securities (MBS)? MBS are relatively liquid because there’s a steady supply of paper. If a steady supply of new Fannie Mae and Freddie Mac paper no longer exists, liquidity will dry up in the older issues. It almost has to. If liquidity dries up, pricing takes a hit. It almost has to, as holders look to sell the older MBS and position themselves in the more liquid paper. This could mean that REITs take mark-to-market hits on their portfolios.
The regulatory capital weighting for banks will also figure in. If banking regulators believe that the government-reinsured mortgage-backed securities have higher credit risk than current GSE paper, then their risk weightings will be higher and banks will be more reluctant to hold them. This would lower demand for paper, which would increase mortgage borrowing rates. In short, there’s a lot of uncertainty for mortgage REITs as they navigate a post–Fannie Mae and post–Freddie Mac world.