The market for residential mortgage securities is now essentially two markets: distressed assets that new funds are popping up to feast on, and a traditional agency/GSE MBS market performing “on mission” – that is, funneling funds from institutional investors back to housing markets. This traditional market has also served an “off mission” function – one not really anticipated by the law and policy makers who designed Ginnie, Fannie and Freddie – by providing liquidity to a range of investors and other market participants as the subprime meltdown drained liquidity from much of the structured products market. Indeed, it was the supply absorbed by MBS markets doing business-as-usual that forced pass-throughs to cheapen dramatically between summer 2007 and mid-March of this year. For instance, the yield spread between swaps and the 30-year Fannie Mae current coupon (a theoretical par-priced security commonly used to benchmark mortgage yields) actually TRIPLED between June 2007 and the peak in mid-March 2008. In general, these are spread levels not observed since the mid-80s, when the first prepayment/new supply assault swamped fledgling MBS markets. The widening in the face of supply explains why mortgage rates, which reflect where loans trade in MBS market, have generally failed to keep pace with declining Treasury yields. Some commentators have not understood that the widening reflected market technicals, and not investors’ view of the GSE guarantee. If it did, Ginnie-backed MBS – guaranteed by a true government agency – would outperform, which is not the case. In fact, it is likely that GSE pass-through spreads would widen on any regulatory oversight that would reduce GSE portfolio purchases. Instead, the widening is largely a response to the technical forces generated by the subprime crisis: waves of new originations sold into pools as “conforming” and FHA/VA mortgages have become, for all practical purposes, the only mortgages available to borrowers. In addition, the market has seen spurts of heavy supply on sales by various MBS holders to raise cash and meet margin calls. As a matter of fact, the shut-down of subprime and Alt-A loan markets has returned the agency/GSEs to their traditional preeminence. From about half of RMBS issuance before subprime hit the fan, the GSEs now account for well over 90 percent of securitized mortgages. But the traditional MBS market is more important than most realize. A fact often overlooked in the brouhaha is the sheer size and liquidity of the traditional MBS market. For example, the US Treasury market is larger – $4.9 trillion of securities outstanding versus $4.3 trillion in MBS at the end of 2007, according to the Federal Reserve Flow of Funds – but coupons in mainstay programs exceed the size of any Treasury issue. For example, the largest Treasury issue currently outstanding is probably the last 2-year note, which came in at $30 billion. By contrast, the tradeable amount of 30-year Fannie 5.5s is $472.2 billion – a number of other 30-year coupons are outstanding in smaller, but still comparable, amounts. Although specific characteristics (such as seasoning, indicators at the loan level of credit-related impediments to refinancing or of greater incentives to refinance, etc.) could give a specific pool extra value, any pool with sufficient remaining principal could be delivered in a TBA trade. In addition to liquidity implied by the amount of outstandings, TBAs trade with a bid-ask spread similar to that of Treasuries, and that bid-ask spread has been reasonably stable throughout the market turmoil. Admittedly, losses, write-downs and financing squeezes have taken their toll upon Street dealers. It’s well known that one very large dealer, Bear Stearns (BSC), has left the mix, but sales and trading personnel have been sharply reduced at a number of other shops as well. Sources in the market generally agree that of 12 or 13 “full service” RMBS shops before the crisis, only six or seven are still fully active. (The other side of the coin is that regional dealers, unmarked by the mayhem in big investment bank structured products, are in a position to acquire market share. For example, market insiders point out that Jeffries Securites, a New York firm, has pulled a group of seasoned mortgage salespeople from RBS, while RBS has replaced them with a group of Bear Stearns pros.) Bottom line, crisis or not, the dealer community has not lost the ability to make markets in traditional MBS. Trading volumes and dealer positions bear witness to the resilience of the traditional agency/GSE MBS market. Total clearing par value of trade settlements are up year over year, according to the Depository Trust & Clearing Corporation. MBS transactions have oscillated in the same range for the last year, according to the Federal Reserve Bank of New York (not all transactions result in settled trades – for instance, originators use forward TBA sales to hedge their pipelines). Likewise, the FRBNY reports that dealer positions have swelled from levels posted last August, reflecting supply from originators and sellers. In mid-March, dealer MBS positions surpassed the previous peak seen in 2003, when historic lows in mortgage rates were accompanied by massive new supply. Signs that the market’s tone – and investor appetites – have improved abound everywhere, but one of the earliest signs that recovery was imminent in “spread” product was the sharp tightening of pass-through spreads from the mid-March historic wides. Versus swaps, for instance, the current coupon 30-year Fannie has retraced about 60 basis points – or half of its previous widening. Whether credit spreads (and equities) are as attractive as the markets have implied in the last week or so of trading remains to be seen. But with a firmer tone in the market, MBS investors have come back to the basic strategies of mortgage investment, many of which are explicitly prepayment plays. With that in mind, the short list of trading strategies that make sense in the current environment:
- Premium-priced pass-throughs and CMOs as well as Interest-Only strips that would benefit from the slower-than-normal prepayments in a tighter credit environment. The data underlying prepayment models reflects relaxation of credit standards and risk-based pricing, not the current tightening trend. Finer-tuned trades will use loan level disclosures to distinguish better values from TBA trades within any given coupon.
- Discount-priced pass-throughs with underlying loan characteristics that suggest prepayments can keep pace with historical norms. For example, pools with concentrations of loans on owner-occupied properties with low loan balances, high FICOs, and geographical locations outside of “distressed markets.”
- Equal duration trades, to take advantage of inconsistent pricing of risks across MBS sector to another. For example, CMOs versus “collateral” (underlying pass-through as a TBA) or otherwise comparable pass-through sectors such as hybrid ARMs or 15-year TBAs. As the market firms, investors will become increasingly sensitive to relative value opportunities across comparable “sets” of mortgage cash flows.
- Trading of outstanding agency/GSE CMO bonds implies, ultimately, a willingness to trade private-issue CMOs and other marginalized paper. Not a lot of paper is trading yet, but color from market players suggests bids for super-senior jumbo and Alt-A paper have begun to come in from the stratosphere.
Editor’s note: Linda Lowell is a mortgage market veteran, and principal of Offstreet Research LLC.
