Mortgage-backed securities (MBS) 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 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 above, we’re looking at the Ginnie Mae 4% coupon for July. For those who have been following this series, the 3.5% was the current coupon last week.
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 104 24/32, which means your lender will make just under 5% before taking into account their cost of making the loan. The borrower will probably get a point or two at that rate.
The Fed is the biggest buyer of TBA paper. Other buyers include sovereign wealth funds, countries that have 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.
FOMC meeting confirmed the market’s worst fears
Two weeks ago, the Fed confirmed that the default path for quantitative easing is to slow down purchases some time this year, with a probable end to the practice in mid-2014. Before the meeting, the market discounted the likelihood of continuing asset purchases by default and withdrawing if we get strong economic data. That probability has now been reduced to zero.
The Fed is confident that the increase in rates will not negatively affect the economy. While mortgage rates are still low by historical standards, the move over the past two months has been breathtaking. Immediately after the FOMC statement, de-leveraging mortgage REITs and loan originators were fighting each other as they needed to sell TBAs. The current coupon Ginnie lost 3.5 points in a week, which is the MBS equivalent of the Crash of ’87. The REIT selling diminished last week and TBAs rallied.
Implications for mortgage REITs
Mortgage REITs, such as Annaly (NLY), American Capital (AGNC), MFA Financial (MFA), Capstead Mortgage (CMO), and Hatteras Financial (HTS), will suffer mark-to-market hits on their portfolios of mortgage-backed securities. For any bond, 3 1/2 points in one week is a big move. For highly levered REITs, this move is exceptionally painful.
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).