Mortgage backed securities are the starting point for all mortgage market pricing, and are the investment of choice for mortgage REITs
When the Federal Reserve talks about buying mortgage backed securities, it is referring to the To-Be-Announced (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 are looking at the Fannie Mae 3% coupon for May delivery.
The TBA market is the basis for which your loan originator prices a loan. When they make a loan to you (as a borrower) your rate is par, give or take any points you are paying. Your originator will then sell it into a TBA. If you are quoted a 3.5% mortgage rate with no points, the lender will fund your loan and then sell it for whatever the current TBA price is. In this case, the TBA closed at 104 17/32, which means your lender will make just under 6 percent before taking into account their cost of making the loan.
The Fed is the biggest buyer of TBA paper. Other buyers are sovereign wealth funds, countries who have trade surpluses with us, 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.
Volatility in the equity markets did not translate into volatility in the MBS market
While we endured some wild swings in the equity markets last week, mortgage backed securities fell slightly, but not dramatically. Fannies rallied five ticks (they trade in 32nds) on Monday on the back of the equity market sell-off and the flight to quality trade, but slowly gave back those gains to close flat by the end of the week. While the past week was relatively data heavy, nothing much happened that would change the view that quantitative easing will probably last through the end of the year.
Implications for mortgage REITs
Mortgage REITs, such as American Capital (AGNC), Capstead Mortgage (CMO), and Hatteras Financial (HTS), are the biggest beneficiaries of quantitative easing, as it helps keep their cost of funds low and they benefit from mark-to-market gains. This means that their existing holdings of mortgage backed securities are worth more as the TBA market rises. The downside is that interest margins compress going forward as 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 due to the fact that they hedge some of their interest rate risk. Increasing volatility in interest rates increases the cost of hedging. This is due to the fact that as interest rates rise, the expected maturity of the bond increases as there will be less prepayments. On the other hand, if interest rates fall, the maturity shortens due to higher prepayment risks. Mechanically, it 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 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 are considered to be guaranteed by the government. That said, Ginnies and Fannie do trade at a spread to each other, with Ginnies trading at a premium due to their explicit government guarantee.
Finally, REITs that are in the origination business, like PennyMac (PMT), will benefit from this move as it will encourage refinancing and make homes more affordable, at least at the margin.