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Taxable Markets
BY Walt Schmidt, Alexis Vilimas and Brandon Messing, FHN FINANCIAL
The MBS Market in Transition from QE to QT
It is helpful to frame a discussion about the market for mortgage-backed securities (MBS) with some basic definitions. First, essentially all fixed-income investments boil down to only three factors: duration, credit and optionality. One could argue that there are two additional factors for certain markets: liquidity and tax implications. But for the purposes of this discussion, we concentrate on only the first three.
Second, the subject of the MBS market will be limited (primarily) to those cash flows guaranteed and issued by the Government-Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac, along with the wholly-owned entity of the US Government, Ginnie Mae. There are other “private-label” issuers of MBS that introduce some form of credit risk and analysis, but that market is not the current subject. Therefore, this discussion will set aside the issue of credit and focus only on the two main factors with which MBS market participants grapple on a daily basis: duration and optionality.
There are three current trends in the market for MBS that drive flows and performance. These trends are related and produce further downstream effects, but market participants should think about the market primarily along these three dimensions:
- The Fed: The current Fed policy is the dominant factor in the MBS market and it produces two very important downstream factors: direct demand for MBS securities and yield curve shape.
- The level of interest rates: This factor is, of course, related to the Fed, as well. But it deserves its own category in that it dictates two of the most important factors for the MBS market, regardless of Fed involvement: prepayments and supply.
- Market technical factors: This category includes demand ex-Fed, regulatory policy, GSE policy and actions, implied volatility, and many other factors that market participants think about and trade from on a daily basis.
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The Fed
The Fed’s retained portfolio, officially known as the System Open Market Account (SOMA), is now slowly declining after peaking at $8.97 trillion on a settled basis in April 2022 (Figure 1). Within that portfolio reside $2.73 trillion currently of MBS securities. This is the most the Fed has ever controlled outright and as a percentage of the outstanding market, although 2015 was close (Figure 2).
Figure 1: Growth in SOMA Exponential Around Covid-19 Lockdowns
Figure 2: The Fed Currently Controls More than 30% of all Agency MBS
As of September 15, 2022, the Fed will effectively no longer purchase MBS securities for the SOMA portfolio. In June, the Fed implemented a policy of “quantitative tightening” (i.e., allowing the portfolio to mature) to coincide with a policy of increasing the fed funds rate that began in March 2022. Due to the fact that the Fed has already begun to curtail purchases of MBS and has signaled that it will effectively cease purchases very soon, the effect on spreads has been predictable. There are many means to demonstrate spreads in the MBS market, and we display two of the most useful in the chart below: 30yr (conventional) current coupon OAS and z-spread.
Figure 3: MBS Spreads Reveal Onset of Covid-19 Lockdowns and Fed Policy
Source: FHN Financial and Bloomberg
MBS spreads gapped wider in March 2020 when the Covid-19 lockdowns and concomitant market volatility/uncertainty put certain levered MBS investors at risk of negative equity. In response, the Fed purchased hundreds of billions of MBS per week for a short period of time before settling on a QE policy of purchasing tens of billions, sometimes more than $100 billion, per month. The MBS market found this policy quite favorable, and spreads moved considerably tighter into 2021 and remained relatively tight for the remainder of the year.
The policy of QE lasted until early in 2022 when the Fed began to prepare the market for fewer purchases of MBS, culminating in the current QT policy of no purchases after mid-September that was outlined above. In response to that signaling by the Fed, spreads have once again gapped wider for most of 2022.
But it is not just market uncertainty that is causing longer-duration/more negatively-convex 30yr MBS to perform wider recently. The benchmark – the US Treasury curve – is very inverted. This means that the benchmark for the longer dated cash flows is lower in yield than is the benchmark for shorter-dated cash flows. There are many curve tenors used to demonstrate this. The most popular for the MBS market is the yield spread between the 10yr and 2yr UST notes, as displayed in Figure 4 below.
Figure 4: Rate Tightening Policy is Causing a Severe Inversion of the 2/10 UST Curve
In short, the current policies of the Fed to both raise rates (thereby causing the curve to invert) and cease direct purchases of MBS are causing spreads to widen to levels not seen before the onset of the Covid-19 lockdowns. Along with the impact on spreads, primary mortgage rates are also much higher than they were last year. We now turn our attention to that important factor for the MBS market.
Impact of Higher Interest Rates
It will come as no surprise that there is an inverse relationship between the level of rates and refinancing activity. That relationship was put into high gear during the past few months as the largest and swiftest backup in primary mortgage rates during the past 20+ years has led to the lowest readings on the Mortgage Bankers’ Association REFI index in more than 20 years. In fact, the recent backup in mortgage rates completely overwhelms what happened during “taper tantrum” in 2013 (Figure 5).
Figure 5: Rates Up, Refi’s Down
The reason that refi activity is so low currently is due to the fact that the MBS market has never been as far “out-of-the-money” for a refi as it is right now. Or, at least that is the case during the past 20 years. The chart below displays a monthly time series of both the average outstanding Gross WAC of the 30yr conventional MBS market and the 30yr primary mortgage rate. That is the average rate that the borrower is paying now vs. the current going rate. That incentive is approximately negative 200 basis points.
Figure 6: The Most “Out-of-the-Money” for the MBS Market in At Least 20 Years
The main effect of the increase in interest rates for investors is the rapidly-plummeting prepayment environment. Payups for call-protection in both the passthru and CMO markets have dropped considerably as all investor types become much more concerned with mark-to-market losses and extension risk than they are now with adding call protection. The many details regarding the changing relative value points within the market are beyond the scope of this article. However, the simple time series graph below of the 3-month CPRs of the three main components of the MBS market clearly demonstrate the change in the prepayment landscape since last year
Figure 7: Market Average Prepayment Speeds Plumb Multi-Year Lows
The other critical impact of the volatility in primary mortgage rates is on issuance. Gross issuance of MBS skyrocketed in 2020 and 2021, only to fall back almost to pre-Covid lockdown levels so far in 2022. On the other hand, net issuance (i.e., net of prepayments) of MBS in 2022 is already greater than the years immediately preceding 2020, because prepayments are so slow. Therefore, any issuance of MBS is additive to the market.
Figure 8: Gross Issuance of MBS Has Plummeted with Higher Rates
Figure 9: Net Issuance of MBS Still Somewhat Above Trend on Slow Prepays
In addition to the direct and indirect impacts of the Fed and interest rate levels on the MBS market, there are a few other technical factors that are worth mentioning.
Market Technical Factors
One of the important technical factors of the market is market capitalization. We have already seen that the Fed owns just over 30% of the MBS market and that the Fed’s holdings are slightly less than $3 trillion in Unpaid Balance (UPB). A simple calculation then implies that the size of the MBS market is near $9 trillion UPB. Actually, the overall agency MBS market is almost $8.5 trillion and the non-agency MBS market is around $300 billion currently. The market breakdowns are provided in Figure 10 below.
Figure 10: MBS Market is Now the Largest It Has Ever Been
This means that almost $6 trillion of MBS paper outstanding is sponsored by entities other than the Fed. The three largest categories of ownership of MBS other than the Fed, in declining market share, are: 1. US domestic banks, 2. International investors (private and official) and 3. US-based asset managers.
In fact, the US domestic bank group is now the single-largest sponsor of the MBS market on the basis of UPB. That is displayed in Figure 11 below, which overlays bank holdings on top of Fed holdings from Figure 2 above.
Figure 11: Banks Have the Largest Influence on MBS Valuations
This fact has enormous implications for relative value in the MBS market. Twenty years ago when the agency MBS market was $3 trillion in UPB, it was dominated by asset managers and the GSEs. These investor types were true “relative value” players who invested to fulfill Total Return mandates either on the basis of intra-sector MBS or cross-sector vs. rates products such as Treasuries and Agencies. Now, the dominant player in MBS (ex-Fed) is a leveraged spread book that cares mostly about accounting earnings in light of the cost of funds. That is a much different relative value mindset, even though many bank PMs have recently developed Total Return methods to try to mitigate adverse implications to the Other Comprehensive Income account.
Another important technical affects a small percentage of the MBS market. But it is a unique issue that does not have a precedent in modern finance: the transition away from the London Interbank Offered Rate (LIBOR). Less than 5% of the MBS market is adjustable-rate in nature, whether in the form of ARMs or CMO floaters. However, due to the uncertainties surrounding the move away from LIBOR for both legacy assets and new issue structures, there is less floating- and adjustable-rate paper available for trading and investing at the very time when short-tenor rates are increasing and investors are looking for such assets.
As Figure 12 below demonstrates, ARM production in SOFR has recovered nicely since late-2020 and early-2021 as the conventional GSEs were transitioning away from LIBOR issuance. However, recent issuance has been below trend relative to 2017, the last time the Fed was engaged in a tightening cycle. Anecdotally, the availability of fuller-cap CMO floaters has been much smaller in this tightening cycle while the “term SOFR” market continues to develop. As of this writing, the GSEs have not yet decided how they will transition legacy CMO floaters and ARMs and when – or whether – they will use “term SOFR” in the future for new issuance (they currently use backward-looking “average SOFR”). They have less than one year to decide, as the regulator for LIBOR, Britain’s FCA, has already determined that LIBOR will not be a “representative” index as of June 20, 2023.
Figure 12: “Average” SOFR-Based ARMs Coming Online, but Market Awaits “Term” SOFR
One final technical from the MBS market that is worth noting is trading flows. Given the drop in issuance and recent mark-to-market losses at financial institutions, trading flows have also suffered a drop. A popular sector among banks of all sizes is specified pools. The chart in Figure 13 below displays both the 30-day moving average and the 12-month moving average of trading flows in the specified pool market. That activity has obviously dropped significantly since 2020-2021 in the 30 DMA data and is now back to pre-Covid lockdown levels.
Figure 13: Trading Flows Have Returned to Longer-Term Historical Run Rates
In conclusion, the MBS market is quickly transitioning from a focus of monetary policy during the past two years to one that needs to stand on its own, really for the first time in its history. Before the Fed, the GSEs were the “buyers of last resort” in the MBS market. Since the GSEs were a relative value investor – unlike the Fed, which was a policy investor – there was some level of spread or performance at which the GSEs would come in and backstop the market. Now, US domestic banks as a collective group are the largest owners of agency MBS. How they invest will determine the value of the sector and within the sector for years to come.