Fannie Mae and the to-be-announced market
When the Federal Reserve talks about buying mortgage-backed securities (or MBS), it’s referring to the to-be-announced (or TBA) market. The TBA market allows loan originators to take individual loans and turn them into a homogeneous product that you can trade. TBAs settle once a month.
Fannie Mae loans go into Fannie Mae securities. TBAs are broken out by coupon rate and settlement date. In this chart, we see the Fannie Mae 3.5% coupon for the November delivery.
TBA market falls as the bond market sells off
The Fannie Mae 3.5% TBA started the week at 103 17/32 and dropped five ticks to close at 103 12/32.
Market participants may also be forecasting less volatility in interest rates. This benefits mortgage-backed securities. Also, the Financial Industry Regulatory Authority (or FINRA) is announcing new margin requirements for TBA securities. These requirements will deeply affect smaller mortgage lenders.
Implications for mortgage REITs
Mortgage REITs and exchange-traded funds (or ETFs), such as Annaly Capital Management (NLY), American Capital Agency (AGNC), Capstead Mortgage (CMO), the iShares 20+ Year Treasury Bond ETF (TLT), and the VanEck Vectors ETF Trust (MORT), are the biggest beneficiaries of quantitative easing. Quantitative easing helps keep REITs’ cost of funds low. REITs benefit from mark-to-market gains. This means 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. This negatively affects mortgage REITs.
As a general rule, a lack of volatility is good for mortgage REITs, which hedge some interest rate risk. Increasing volatility in interest rates increases the cost of hedging. This is because as interest rates increase, the expected maturity of the bond increases because there will be fewer prepayments. On the other hand, if interest rates decrease, the maturity shortens due to higher prepayment risks.