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 November delivery.
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 4.5% 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 105 30/32, which means your lender will make just about 6% before taking into account their cost of making the loan. The 4% coupon is now a cuspy coupon and we could be best-exing into a 3.5% security soon.
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 market focused completely on the Fed and the shutdown
With the shutdown now behind us, the focus shifts to the Fed. Most participants seem to be coming to a consensus that we won’t see any changes in quantitative easing this year. The March meeting will be enough time to see if the first shutdown had any economic effect and whether we get through the next set of deadlines.
Implications for mortgage REITs
Mortgage REITs—such as Annaly Capital (NLY), American Capital (AGNC), MFA Financial (MFA), Capstead Mortgage (CMO), and Hatteras Financial (HTS)—announced big drops in book value per share, as rising rates hurt the value of their mortgage-backed security holdings. The REIT sector has been de-leveraging in order to take risk off the table.
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).