As discussed earlier, the supply of mortgage-backed securities (MBS) continues to fall behind the potential demand – even with the Fed’s taper in place. New issuance has steadily declined over the past year, with the Fed becoming an increasingly larger…
Today’s Washington will never bring charges against big banks’ major Wall Street criminals – criminal charges, that is.
While we’ve discussed some of the economic implications of the Fed’s current policy, let’s now take a quick look at the impact of QE on the overall mortgage bond market.
Here is a simple fact: the amount of mortgage-related securities in the US has been declining since 2008 – after reaching just over $9 trillion at the peak.
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| Source: SIFMA |
The reason is simple. With a large portion of all mortgages funded via the bond markets, the ongoing decline in total mortgages outstanding results in smaller MBS balances. Of course as the population grows and more homes are built (albeit very slowly) this trend should reverse.
And now with these market dynamics as the backdrop, put the Fed into the mix. At it’s current pace the Fed is taking about half a trillion of MBS securities out of the market. In fact the Fed is now removing more than 100% of the paper that is being issued. The supply of agency (Fannie and Freddie) MBS securities in the market is declining sharply as the Fed reduces the total “tradable float”. According to Credit Suisse, without the Fed’s anticipated taper in Q1, the demand for agency paper could outstrip the supply by $340bn in 2014, creating a liquidity problem.
CS: – Liquidity in the MBS market could come under pressure in the coming months due to Fed’s settled purchases exceeding 100% of gross issuance of non-specified conventional 30-year pools. Tradable float in conventional 30-year MBS should decline between 6% and 30% during the year, increasing the risk of a potential liquidity disruption in the market under longer taper delay scenarios.
As a result some of the private participants, particularly banks, have been reducing their agency MBS holdings. The chart below shows the year-over-year changes in MBS holdings by commercial banks.
Here is what the conventional 30-year agency MBS float will look like under the taper vs. no-taper scenarios (chart below). Without the taper, the float in these bonds will decline by 30% from the October levels. These are dangerously low levels for what used to be one of the largest bond markets in the world.
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| Source: Credit Suisse |
Taper therefore becomes essential in order for liquidity to stabilize and for more private market participants to begin returning to this market.
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The recent increase in long-term rates is causing major changes in the mortgage markets. Here are some key trends:
1. Refinancing activity continued to decline through Q3. The proportion of mortgage applications for purchase vs. refi has doubled this year (and that’s not because of higher demand for homes).
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| Source: DB |
2. A number of lenders who focused on mortgage refinancing such as US Bank, Provident Funding, and Flagstar are struggling (although the largest banks such as Chase and Wells seem to be less affected). This may result in an increase in the number of riskier mortgages.
DB: – Lenders who specialized in refinancing transactions have experienced dramatic loss of market share and either will have to become more competitive on rates in growth sectors such as ARMs to regain market share or loosen credit standards.
3. While a larger number of buyers now prefer ARMs, the dynamic within the fixed rate universe is a greater demand for 30-year mortgages vs. 20 or 15. That’s because the monthly payments on 30-year mortgages are lower (slower principal repayment) and buyers are looking for the cheapest solution.
DB: – As interest rates have risen and volume has dropped, the product mix has shifted sharply … 30-year mortgages are much more popular with homebuyers—more than 50% of 30-year mortgages are used for purchase transactions but less than 20% of shorter-term mortgages. As a consequence, the share of 15-year mortgages fell from 20% in September to 17% in October as the share of 30-year lending rose to 63% from 59%. Meanwhile, the ARM share has doubled to more than 5% since June as HARP’s share of lending has fallen to 3% from a high of 7% this spring.
4. As a result, MBS bond markets are taking a hit in the form of lower volumes. The sharp decline in refinancing activity has reduced the need to issue new agency mortgage bonds. New issuance is the lowest in years.
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| Source: SIFMA (note: this includes CMBS but the bulk of the activity is agency MBS) |
Similarly, trading volumes in MBS have dropped off to new lows.
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| Source: SIFMA |
Here is a summary on US mortgage markets from Freddie Mac (who, just as Fannie Mae, has been issuing fewer bonds):
Frank Nothaft, Freddie Mac Chief Economist: – With the close of 2013 will also come a major transition in the housing finance industry. For the first time since 2000, we’re going to see the mortgage market dominated by purchase activity as the refinance share drops below 50 percent. And with mortgage rates rising, we’re also going to see the home-sales gains as well as the impressive house price growth begin to moderate to more sustainable levels.
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Today, in New York, investors will be pitched the first-ever REO-to-rental securitization deal. The $500 million deal bundles foreclosed single-family homes, “real-estate-owned” by Blackstone Group, into securities that pass-through rental payments to investors.
The new securitization of rental properties comes at a time when home prices have rebounded dramatically across the country. But rather than confirming a bull market in housing, the “trade,” as Reuters calls the transaction, likely heralds a coming double-dip.
The upward trajectory of housing prices, fueled by private equity companies and hedge funds’ cash purchases, now faces institutional liquidity demands – and their potential exit.
Here’s what the Blackstone deal is all about, why its structure is problematic, how the ratings agencies will view it, and what it portends for the future.
“Wind down the two companies and end their longtime implicit guarantee” is a hell of an undertaking, considering that transferring these agencies into private hands did not work so well the last time. What about simply getting rid of them?
Rather, Bernanke said, “given weakness in the labor market – the fact the unemployment rate probably understates the weakness of the labor market – and given where inflation is, I would suspect it may be well some time after we hit 6.5% before rates reach any significant level.
Mortgage backed securities (MBS) have sold off sharply over the past month as fixed income markets face the new reality of rising rates.
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| Mortgage News Daily |
But unlike most other fixed income securities, MBS duration tends to increase with yield. That’s because higher MBS yields typically mean higher mortgage rates and lower mortgage refinancing activity (which we have already seen). Pools of mortgages backing many MBS, particularly loans with lower coupon, will experience slower prepayment speeds going forward. Slower refinancing extends the effective duration of the bonds (illustration below).
If you have a 30-year mortgage at 3.6%, it is now less likely you will refinance any time soon (mortgage rates today are above 4%). One reason your mortgage is not treated as a full-term 30-year note is the probability that you will sell your house, thus terminating the note. There is also some probability that in the future, mortgage rates will drop below 3.6% again, providing you another opportunity to refinance. The expected average life of your 3.6% mortgage and the security that is backed by your loan has therefore been extended (from you potentially refinancing in the next six months to you selling your house in say 5 years). And if rates rise further, prepayments will slow even more. The chart below shows the prepayment speed (PSA) for just such a security over the past month as well as the expected prepayment speeds going forward. It also shows what happens if rates increase by another half a percent.
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| Source: CS |
What does this mean for investors who hold MBS or actual pools of mortgage loans? They own securities that become riskier (more sensitive to rates) as rates rise. These portfolios have what’s often called a “negative convexity” risk profile. To combat rising durations of their portfolios and therefore higher exposure to rates, many investors now have to short longer dated treasuries or rate swaps. And until recently many MBS investors haven’t been doing much hedging because the hedge (the treasury short positions) has consistently lost them money. Now many are jumping in – all at the same time – to put the hedges on. And that hedging is putting downward pressure on treasuries (upward pressure on yields).
Bloomberg: – As rates increase, the expected average lives of mortgage bonds and loan-servicing contracts extend as potential refinancing drops, leaving holders more vulnerable to losses from rising rates. Investors then may seek to pare the duration risk or rebalance existing hedges by selling longer-dated Treasury securities, mortgage bonds or transacting in interest-rate swaps or options on those contracts, sending yields even higher and spreads wider.
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One measure of duration of agency mortgage bonds rose to 4.8 years last week from 3.7 years in April, Barclays index data show. The duration of Fannie Mae (FNMA)’s 3.5 percent debt, which is now 6.2 years, would rise to 7.8 years if rates rise 1 percentage point, according to Bloomberg’s prepayment model.
This mortgage-driven rise in rates happened before – in 1994 and again in 2003. The act of shorting (selling) treasuries increased yields, raising MBS durations and forcing more treasury selling. Some have referred to this market dynamic as the “convexity hedging spiral”.
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| The 1994 convexity hedging impact |
Of course this is not 1994 (or 2003 for that matter.) At least for the time being, the Fed is still buying massive amounts of both MBS and treasuries. And all that buying limits the impact of convexity hedging. Treasury sellers that want to hedge portolios always find one large buyer with “deep pockets”.
Bloomberg: – “The actual convexity hedging flows will be less when rates rise this time than it was in the past,” Dominic Konstam, the global head of interest-rates research at Deutsche Bank … The hedging “was massive in 2003, and we won’t see a repeat of that. With the Fed holding so much of the mortgage paper, it really knocks down the amount of mortgage hedging needed when yields rise.”
What will happen once the Fed ends its program however is anyone’s guess.
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This is a syndicated repost published with the permission of Money Morning. To view original, click here. Opinions herein are not those of the Wall Street…
After this post in early December discussing the possibility that MBS, particularly the 30yr FNMA had become a “crowded trade”, we’ve received numerous e-mails arguing that based on the Fed’s recent actions, agency MBS has more upside. Furthermore…
