Mortgage-backed securities 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 below, we’re looking at the Ginnie Mae 4% coupon for September.
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 103 21/32, which means your lender will make just about 3.5% before taking into account their cost of making the loan.
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.
The ten-year bond yield breaks out of its trading range
Last week the ten-year bond broke out of its recent 2.57%-to-2.74% trading range. The headline catalysts (the unemployment report on Thursday, and unit labor costs on Friday) seem to be somewhat forced. The catalyst could have been Wednesday’s Treasury International Capital Report, which showed foreign investors were big sellers of U.S. financial assets. Foreign sovereign wealth funds may be getting ahead of the Fed a little bit in anticipation of the end of quantitative easing.
The liquidity in Ginnie Mae securities was markedly lower last week. Typically, Ginnie Mae TBAs trade with bid/ask spreads of a couple of ticks (2/32 or about 6 basis points). Last week, spreads in the current coupon TBAs were 8 or 9 ticks. In the higher coupons (5% and up), they were 3/4 of a point. This lack of liquidity flows through to mortgage rates.
Implications for mortgage REITs
Mortgage REITs—such as Annaly Capital (NLY), American Capital (AGNC), MFA Financial (MFA), Capstead Mortgage (CMO), and Hatteras Financial (HTS)—are beginning to announce earnings. Last week, we heard from the biggest mortgage REIT, Annaly Capital. Like all REITs, it experienced a drop in book value due to the second quarter bond market sell-off. It turned out that it was less levered than its competitors and therefore its book value per share held up better.
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).