Market Memo: How the 'Fed effect' turns the MBS market on its head
Housing appears to be in the early stages of a sustainable recovery—single-family starts hit a four-year high in January, and housing prices and year-over-year sales are at multi-year highs. But the evidence of housing’s growing strength is hard to glean from the mortgage-backed securities (MBS) market.
In a typical recovery, increased housing demand and rising home prices would work to push interest rates up, prepayment risk down and spreads—the gap between rates on mortgages and comparable-maturity Treasury securities—narrower, all forces that generally favor residential MBS. But the Federal Reserve’s open-ended quantitative easing (QE)—$60 billion to $65 billion of monthly agency MBS purchases as well as $45 billion a month of longer-term Treasuries—has made this anything but a typical market.
Even though 10-year Treasury yields have broken above 2% for the first time in 10 months on improving economic fundamentals, yields at best are on par with inflation and significantly below where they normally would be at this stage of an economic cycle were it not for the Fed. Mortgage rates also continue to hold near record lows, largely because the Fed’s MBS purchases essentially are offsetting selling in the marketplace. These repeated QE programs leave incrementally less upside potential for MBS as the element of surprise is long gone and already thin spreads limit potential tightening. The result is the residential MBS market has less to do with interest rates than it does with less traditional factors such as Washington politics.
Indeed, consider prepayment and extension risk. Extension risk would be more typical for this juncture of the market. It usually occurs when mortgage rates start to rise as a housing recovery takes hold, slowing incentives for borrowers to prepay their mortgages and thus pushing out—or extending—the average maturity of an MBS portfolio. Prepayment risk, on the other hand, tends to occur when rates are heading lower and mortgage holders refinance to take advantage of lower rates. But even though mortgage rates are more likely to rise than fall in coming months, rising home prices have prepayment risk on the rise, not only from homeowners wishing to cash out but also from formerly underwater borrowers (their home equity fell below what they owed when prices plunged) hoping to get out. About a fifth of residential mortgages were underwater last September, according to research firm CoreLogic.
Policy intervention adds to market confusion
Another prepayment factor to consider comes from the regulatory side of things. President Obama has come under increasing pressure from his own party to replace the acting head of the Federal Housing Finance Agency, Edward DeMarco, who has butted heads with House Democrats and outgoing Treasury Secretary Timothy Geithner over his refusal to reduce the principal on underwater mortgages held by Fannie Mae and Freddie Mac, the two government-sponsored enterprises the FHFA oversees. DeMarco’s critics are pushing for much more aggressive refinance-friendly policies for underwater mortgages than available under current mortgage-modification programs. One potential bill would allow borrowers to fill out post cards to complete a refinancing. The market understandably is less than thrilled with such continued uncertainty.
All of the above has left us neutral on the residential MBS market. The commercial market is a different matter. Demand and prices for commercial properties are on the rise, a factor of a plodding economic recovery that is generating just enough jobs and income for gradual improvement but not so much that the Fed will move to the sidelines soon (though minutes from their January meeting hinted policymakers may tweak the bond buying when they meet again next month). The risk of a policy mistake out of Washington is always there, but one that’s becoming increasingly discounted by a private marketplace that’s frankly growing tired of thinking about it. Moreover, while all the QE has effectively tightened spreads across the board as investors continue to flee low-yield government and agency securities in search of higher yields elsewhere, the commercial MBS market is somewhat divorced from direct central bank influence. This has lessened the “Fed effect’’ that is so evident and substantial on residential MBS.