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 (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’re looking at the Fannie Mae 3.5% coupon for July. Followers of this weekly piece may notice the change in coupon. As rates have risen, the current coupon Fannie Mae TBA will probably shift to 4% next week.
Loan originators base loan prices on the TBA market. When they make a loan to you (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 100 16/32, which means your lender will make close to 0.5% before taking into account its cost of making the loan. For borrowers to get the sub 4% mortgage rate this security represents, they’ll have to pay several points.
The Fed is the biggest buyer of TBA paper. Other buyers include sovereign wealth funds, countries with trade surpluses with the U.S., 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.
Mortgage-backed securities under immense pressure as the Fed takes away the punch bowl
Last week’s FOMC meeting made mortgage rates jump the most they have in almost ten years, as the Fed told markets that the default path is to begin tapering quantitative easing this year and that it will change that approach only if the economic data comes in weaker than expected.
The amount of leverage used by mortgage REITs has caused them to de-lever in a difficult environment. The Street has been waiting for a convexity hedging moment out of the REITs, but so far this moment has yet to materialize. Since the bond market began its sell-off, mortgage REITs have underperformed.
Implications for mortgage REITs
Mortgage REITs such as Annaly (NLY), American Capital (AGNC), Capstead Mortgage (CMO), MFA Financial (MFA), and Hatteras Financial (HTS) are getting crushed as rates move up. For a highly levered REIT, a drop of 3 points in a week is a nightmare. For REITs, the fear has quickly gone from prepayment risk to mark-to-market hits.
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 prepayments. On the other hand, if interest rates fall, the maturity shortens due to higher prepayment 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 Fannie Mae MBS yield so much more than Treasuries. While Fannie Mae mortgages (unlike Ginnie Mae mortgages) don’t carry an explicit government guarantee, they are “government-sponsored” and considered government-guaranteed. That said, Ginnies and Fannies do trade at a spread to each other, with Ginnies trading at a premium because of their explicit government guarantees.