Tuesday, December 16, 2008

Mortgage Backed Securities: Its a trap!

From the Accrued Interest blog:

The agency-backed mortgage sure is tempting. Fannie Mae 30-year 6% mortgage-backed securities are currently yielding in the 4.40% area with just a 2-year average life, based on Bloomberg figures. That looks pretty good compared with 2-year Treasuries at around 0.66% and 2-year Fannie Mae bullet debt at around 1.50%. Now that Fannie Mae and Freddie Mac are owned by the government, one should view these credits as all the same. Why not take that extra yield?

But beware, there is likely to be a massive difference in MBS performance over the next year, as the government works hard to push mortgage borrowing rates lower. When a borrower repays his/her mortgage in part or in full, that repayment is passed through to the investor at $100. With almost all agency-backed MBS priced at $102 or above, investors will be taking a loss on every loan refinanced. Thus gauging the potential refinancibility of your mortgage-backed security as well as predicting the direction of government policy will be the key. This is especially true of those holding agency CMOs, which remains a popular product among individual and bank investors.

First question is, how low can mortgage rates go? According to Bankrate.com, the national average mortgage rate is now 5.57%, with GSE conforming mortgages probably available in the 5.25% area this week based on forward commitment rates. Rates could easily fall much further. The long-term average spread between the 10-year Treasury and mortgage rates is 152bps, the current spread is 300bps. Given that the Fed has pledged to buy $500 billion in agency MBS in 2009 (equal to half of 2008's total issuance), there is every reason to believe the spread between Treasury and mortgage borrowing rates will fall, at least for GSE conforming borrowers.

Currently about 80% of the fixed-rate agency MBS universe has a rate of 6% or above. Under normal circumstances, we'd expect most of those borrowers to refinance. However, conventional wisdom says the combination of declining borrower equity and strict lending standards are likely to mute refinancings.

Yet despite the national average home price declines, most borrowers within the agency universe probably still have strong equity. The FHFA's Home Price Index (formerly OFHEO) has only declined by 4% year-over-year. In terms of general economics, the Case-Shiller index probably better represents the housing picture. But remember that the FHFA index is calculated by looking at homes with GSE mortgages, so its exactly the relevant index for agency MBS investors.

All this leads to a highly divergent degree of refinancability among agency MBS pools. If you have a pool originated in 2007 with 90% loan-to-value (i.e., 10% equity) those borrowers will struggle to refinance in today's tight credit environment. A pool where the original loan-to-value was 75% and which was originated in 2005 might be highly refinancable should rates continue to fall.

Geographics will also be crucial. Only 21 states have actually experienced price declines according to FHFA, with some very large states suffering outsized declines. A pool with mostly Midwest or Southeastern exposure would not have many underwater mortgages, whereas a pool concentrated in the Southwest would. The former will repay much quicker than the later.

Mortgage prepayment speeds are especially dangerous for investors in collateralized mortgage obligations (CMOs). A CMO structure is dependent on prepayment speeds occurring within some range. But what we are likely to see is some pools pay extremely fast while others pay extremely slow. This kind of bifurcation could easily bust CMO structures and leave investors with cashflows wildly different from what was expected.

The big wild card is government policy. There is talk that Treasury might allow for no-appraisal refinancing, basically lending based on original loan-to-value as opposed to current loan-to-value. Debate the wisdom of this policy as you might, it would case a massive refinancing wave that would make 2003 look like a a splash in the kiddie pool.

Are mortgages worth owning? Sure, but beware of the risks. Investors who need more certain cash flows should look elsewhere. Investors focused on income and who are willing to dig into the specifics of a mortgage pool can find great rewards.

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