Fannie Mae and the to-be-announced (or TBA) 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 the chart below, we see Fannie Mae’s 3.5% coupon for February delivery.
TBA market rises along with the bond market
The Fannie Mae 3.5% TBA started the week at 105 22/32 and gave up 22 ticks to close at 105. The ten-year yield increased 32 basis points. Interestingly, mortgage rates only increased by 3 basis points, meaning bankers are taking a “wait and see” attitude towards the recent bond market sell-off.
As interest rates have fallen, we’ve seen TBAs lag bonds. This has been due to changing prepayment assumptions. For example, consider the Fannie Mae 3.5% bond above. If you bought the bond for 105, you know you’re going to get par eventually for it. This means the crucial question is how many coupon payments you’ll receive before you get prepaid. This means that as rates fall, you could actually see TBAs fall as well, due to increased prepayment speeds. This is one of the strange features of mortgage-backed securities, and it reflects the negative convexity inherent in these securities.
Implications for mortgage REITs
Mortgage real estate investment trusts (or REITs) and ETFs like 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 non–central bank holders of TBAs.
In general, you can consider mortgage REITs to be among the biggest lenders in the mortgage market. When TBAs rally, it means capital gains for mortgage REITs. These increase their return, especially when added to their interest income.
You should take caution, however. Since REITs use leverage, volatility in interest rates can work against them. We saw American Capital Agency report this week, and despite a huge rally in bonds in the fourth quarter, its book value per share only increased by a small amount.