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March 25, 2010 8:23 pm
Fortunes on Wall Street have risen and fallen over the years thanks to an esoteric part of the capital markets, which is also one of the world’s biggest: mortgage-backed securities.
The financial crisis of 2008 thrust this market into the spotlight, as trillions of dollars were lost across the globe. It was far from the first time – losses on mortgage-backed debt played a big role in bond market blow-ups resulting from big interest rate shifts in 1994, 1998 and 2003.
Now, less than 18 months after the mortgage markets went into a tailspin, a sense of calm has returned to a key part of the $14,000bn market of outstanding US home loans: the more than $5,000bn of mortgage-backed securities sold by government-backed mortgage corporations Fannie Mae and Freddie Mac.
This so-called “agency MBS” market has been supported for more than a year by the presence of a huge buyer in the form of the Federal Reserve. By the end of this month it will own $1,250bn in bonds, or slightly less than a quarter of the market.
But the Fed’s buying will end next week, on March 31, meaning this vital cog in the US housing system is entering a period of uncertainty.
The purchases – part of the Fed’s “quantitative easing” programme – have played a vital role in stemming the effects of the financial crisis on the US economy.
“Borrowing costs for consumers have fallen, MBS spreads have narrowed and risk assets have rallied – all of which have been, arguably, intended or welcome consequences of the programme,” says Larry Hatheway, an economist at UBS.
The Fed’s buying also tried to stem the collapse of the US housing market by helping home owners refinance their loans at lower rates. But the impact of lower rates has been counterbalanced by other factors such as a glut of unsold homes, record foreclosure rates, tighter credit standards and rising unemployment. These have curbed the scale of the “refi” boom that has often boosted consumer spending in the past.
“For homeowners, [the Fed programme] promoted perhaps the best refinancing opportunity in about 50 years in terms of rates,” says Keith Gumbinger, vice-president at HSH Associates, a mortgage analyst. “But underwriting conditions remain tight. You need to have a fairly deep equity position, good documentation and good credit.”
The Fed’s announcement of its programme in November 2008, when it initially planned to buy $500bn of MBS, sparked a huge drop in 30-year fixed rate mortgages backed by Fannie and Freddie. That translated into a drop of nearly a full percentage point for mortgages held by homeowners. The homeowner rate subsequently reached a fifty-year low of 4.92 per cent in December 2009. It is currently just above 5 per cent, according to HSH.
By intervening in the agency MBS market, the Fed has kept alive mortgage finance. The market for securities backed by private mortgages – as opposed to the mortgages bought by the government-backed mortgage agencies – has failed to revive. As a result, the agency MBS market now funds 90 per cent or more of the US mortgage sector.
UBS estimates that without the MBS purchase programme, benchmark 30-year mortgage rates for consumers would be about 5.5 per cent, half a percentage point above their current level.
As for the housing market itself, UBS says that “activity has not recovered strongly, though in the absence of the MBS plan (and other Fed and government support), conditions almost certainly would have been far worse”.
When the Fed finally stops buying agency MBS next week, it will have implications for US mortgage rates – which use the MBS yields as a reference point – as well as for the banks and other investors that own such securities. These include Chinese and Japanese central banks. These foreign holders of agency MBS will be reassured by the fact that the US government is set to continue supporting Fannie and Freddie for now, with decisions about a possible restructuring of the agencies pushed into the future.
So far, the MBS market itself has reacted calmly to the prospect of the Fed’s exit, helped in part by the assumption that the Fed will hold on to its $1,250bn portfolio, rather than sell it. Ben Bernanke, the Fed chairman, and other officials have said that while the central bank ultimately wants to return its balance sheet to holding just Treasuries, selling its mortgage holdings – which account for about half of its balance sheet – will not occur until the economy is showing a sustainable recovery.
Indeed, a shortage of top rated debt – Fannie and Freddie are rated triple A and have the unlimited backing of the US government – and persistently low official interest rates have banks and money managers seemingly eager to stock up on agency MBS.
The clearest indication of the calm is in the price: even as rates had been expected to rise in anticipation of the end of the Fed buying, yields on agency MBS have instead fallen to record low levels compared with US Treasuries.
The spread on Fannie Mae’s current coupon 30-year bond, the benchmark, is about 60 basis points above the 10-year US Treasury yield. In late 2008, the spread peaked at 220bps.
“This suggests that other buyers are stepping in to fill the void being left by the Fed,” says Dan Greenhaus, strategist at Miller Tabak & Co.
The question is, what happens next in the agency MBS market, and to mortgage rates.
On the one hand, a yield pick-up of 60bps over US Treasuries for triple A rated debt is attractive, especially to banks that can borrow at near-zero interest rates and for bond funds that continue to see huge amounts of new money. Indeed, banks have loaded up on agency MBS.
“There is a scarcity of competing asset classes for fixed income managers and it will remain that way for some time,” says George Goncalves, head of fixed income strategy at Nomura Securities.
On the other hand, the dynamics of these huge markets are incredibly difficult to predict.
Just this week, the relationship between US Treasury yields, swap yields and mortgage yields appears to have shifted (see above). And, if interest rates do rise, mortgage bonds are unlikely to remain unscathed, not least because higher interest rates affect not only the yields but also the likely lifespan of the bonds.
It is this complex interplay between rising interest rates and the value of mortgage-backed bonds that has often resulted in unexpected, but large, losses on positions in the mortgage market in the past.
Should the economy falter later this year, or mortgage rates rise too sharply, the Fed has intimated that it could decide to buy more bonds and counter such a move. The Fed’s broader moves on interest rates will also be crucial.
“My concern now is the risk that people may have become a little too complacent,” says Scott Wede, head of agency mortgage bond trading at Barclays Capital.
The MBS market explained
The US housing market has grown to become such a large part of the US economy due to the ability of banks to sell on mortgages to investors, through mortgage-backed securities markets. This meant they could keep making new mortgages as long as MBS continued to be sold on.
The MBS market has been split. The “agency MBS” market consists of bonds backed by mortgages owned by government housing agencies Fannie Mae and Freddie Mac where the source of the income from the bonds are the mortgage payments.
Although Fannie and Freddie have the backing of the government, the value of the MBS can still fluctuate depending on interest rates and home-owner repayment patterns.
The “private label MBS” grew before the financial crisis, and consisted of securities backed by mortgages not bought by Fannie and Freddie.
Plunging house prices and soaring mortgage defaults resulted in the loss of hundreds of billions of dollars, with many securities that had been rated triple A downgraded. There have been no new private label MBS deals for two years, with sales of agency MBS virtually the sole source of new financing for the US mortgage market.
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