Why Fannie Mae TBAs reacted constructively to Yellen’s testimony
Trading in Fannie Mae TBAs
When the Federal Reserve talks about buying mortgage-backed securities (or MBS), 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 below, we’re looking at the Fannie Mae 4% coupon for December delivery. Followers of this weekly piece may notice that the coupon keeps changing.
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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% 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 26/32, which means your lender will make just under 5% 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.
How did Janet Yellen’s testimony affect TBAs?
Janet Yellen didn’t give any indication that she would pursue policies that are different than current monetary policy. In a nod to the sell-off in the bond market over the summer, she said that the Fed would endeavor to be even more communicative. It’s important to keep in mind that there are two levers in use—low interest rates and quantitative easing (or QE). Often, the Fed may be referring to monetary policy being in place for the foreseeable future, and it’s referring to the Fed Funds rate, not QE.
After all the speculation that the Fed would start reducing purchases, it stood pat at the September meeting and made no changes. It made the same decision in October. The Fed is in a bit of a bind on the MBS (mortgage-backed securities) side, as demand for MBS is low while the REITs delever, fixed income funds continue to experience withdrawals, and foreign investors continue to sell. If TBAs drop in price, that means higher mortgage rates, and the Fed won’t want to risk damaging the budding recovery in real estate.
Implications for mortgage REITs
Mortgage REITs, such as Annaly (NLY), American Capital (AGNC), Capstead Mortgage (CMO), MFA Financial (MFA), and the Mortgage REIT ETF (MORT), 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 MBS 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 rates 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 don’t 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.