December Agency MBS Update

Monthly Commentary

January 05, 2017

December 2016 saw a tale of two markets. The opening of the month was characterized by higher interest rates and volatility, while the year closed with a tempering of the post-election storm. It opened with a similar tone to November, with a strong nonfarm payroll number (+268k) pushing risk asset valuations and interest rates higher. The most impactful market event hit mid-month, with the Federal Reserve choosing to raise the Federal Funds rate 25 basis points for the first time since December of 2015. In announcing the decision, the FOMC also raised expectations for the future path of interest rates, jolting markets and sending the 10yr U.S. Treasury yield to the highest level (2.62%) since 2014. The end result was a sharp widening in the agency MBS basis as investors upgraded the chances that supportive monetary policy will erode in the coming calendar year. The negative reaction of mortgages to the only interest rate hike of 2016 faded into the holidays. The curve steepening and march toward higher overall interest rates that have been persistent market characteristics since early November abated. The result was a sustained rally in the agency MBS basis over the final two weeks of 2016 that brought monthly excess performance back to positive territory in December. In aggregate, the Barclays MBS Index outperformed benchmark U.S. Treasuries by 6 basis points in December, with 2016 performance closing down just 11 basis points for the year 2016.

The coupon stack performance in December was mixed, reflecting a changing market landscape of higher interest rates and worsening carry. Conventional coupons were varied, with lower coupons generally outperforming their higher coupon counterparts. Fannie Mae 30yr (FNCL) 3s came in up 18 basis points (bps) relative to benchmark U.S. Treasuries, while FNCL 4s were up just 8bps, and premium coupons struggled. With prepayments set to slow down across the agency MBS universe, the value of investing in coupons with high levels of burnout seems to have dissipated somewhat for market participants. The story was different in Ginnie Mae (G2SF) coupons, with every coupon except the G2SF 4.5 demonstrating positive performance. Marginally higher interest rates benefitted G2SF collateral, with relatively shorter durations attracting investors as mortgage rates rose. There was marginal outperformance for 15yr collateral for many of the same reasons. With Interest rates setting up materially higher from their levels just a few months ago, the entire coupon stack has had to adjust to an entirely different landscape. After a year in which the major risk factor for most coupons was elevated prepayments due to low mortgage rates, investors now have to contend with extension risk being a major factor in many lower coupons. In context, the 30yr mortgage rate went from 3.62% at the start of the fourth quarter to 4.41% to end the year. The enormity of that change in just three months will have far reaching effects across the coupon stack as well as for prepayments in the year ahead.

The prepayment report released at the start of December showed prepayments slowed again in November, yet once again speeds were above expectations. The faster-than-expected speeds is a continuing trend that would be highly worrisome for agency MBS valuations were it not for mortgage rates rising dramatically during the time period in question. The higher mortgage rates should quell the uptick in prepayments seen because of the summer dip in mortgage rates. The speeds will most likely change meaningfully in the coming months. Other nuggets gleaned from the report include: The headline saw 30yr prepayments came in down 5%, ending up at 18CPR. Lower coupons saw the biggest decline in speeds, with FNCL 3s coming in down 8%. Freddie Mac collateral dropped 6%, a modest difference from the decline in Fannie Mae speeds. The slow lower-coupon speeds imply that turnover dropped in November, but whether that trend continues remains to be seen. The extremely fast speeds in both the FNCL 3.5 and 4 2014 cohort continued in November, as speeds dropped just 5%. The prepayments in this cohort have yet to slow down meaningfully from the peak of refinance activity this summer and thus continue to negatively impact the TBA deliverable. Prepayments in FNCL 4.5 coupon actually came in faster on the month in 2015 and 2016 vintages, further weighing on the coupon that saw the worst monthly performance in December. Overall, while prepays have not slowed as much as anticipated thus far, a marked decline in speeds appears to be just around the corner in 2017. The regulatory news in December was sparse, with speculation about the incoming administration dominating actionable news. One notable evolution to the agency MBS landscape was announced for 2017 by the Federal Housing Finance Agency (FHFA). The FHFA declared that conforming loan limits would rise in 2017. The conforming loan limit is the maximum loan size that Fannie Mae and Freddie Mac are allowed to underwrite for agency MBS. The Housing and Economic Recovery Act of 2008 establishedthe limit at $417,000 in loan size for most markets. Due to declining home prices that followed, the limit has not been adjusted upward until this year when housing prices surpassed their pre-crisis peak. The new thresholds will be $424,100 for lower cost areas, and $636,150 in high cost areas, rising from the previous level of $625,250. While the limit changes themselves will have only a very minor impact on the agency MBS market, housing prices rising above their pre-crisis peak levels is an important milestone for the Amerin housing market in the post Great Recession aftermath. Looking to 2017, the changing regulatory landscape is going to be a focal point for agency MBS investors. The market will be looking for any clues as to the future of the GSEs, as well as the host of post-crisis regulations and policies that could be impacted by changing regulatory and executive management.

In aggregate, the month of December ended up being somewhat reflective of the year in mortgages overall. The nearly flat overall performance belies a year in which extended periods of sustained outperformance of agency MBS relative to Treasuries were punctuated by brief spurts of heightened volatility that stripped agency MBS of value. An early year swoon in risk assets, the surprising decision by voters in Britain to leave the European Union, and the largely unforeseen results of the U.S. presidential election, each contributed meaningfully to agency MBS underperforming benchmark U.S. Treasuries in 2016. While not surprising that periods of heightened volatility are negative for agency mortgage valuations, it is instructive to be thoughtful about implications for the sector as the calendar flips to the New Year. As we look forward to 2017, increasing interest rate volatility, the specter of a potentially less supportive Federal Reserve, and regulatory uncertainty are all reasons to remain cautious about the carry and return profile offered in agency mortgages for the year ahead.





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