Agency MBS performance shot out of the gate quickly in the New Year and posted
positive relative and absolute performance to open 2019. A dovish pivot by the
Federal Reserve in December buoyed global risk markets, reducing concern that
tightening monetary policy would spell the final chapter of the decade-long postfinancial
crisis bull market. A perceived lowering of global trade tensions further
benefitted risk market valuations, with market participants judging that progress is
being made in trade negotiations between China and the United States. While the
United Kingdom’s attempt to leave the European Union continues to pose some
risk to global markets, because the ultimate result remains very much in doubt,
the headwind was not enough to disrupt the positive tenor worldwide. The result
was agency MBS sailing into positive territory on the back of the strong tailwinds.
Further benefitting agency MBS investors, interest rate volatility dropped markedly
in the month of January. With U.S. Treasuries staying in a tight range, agency MBS
received the benefits of reduced volatility in concert with rising global risk market
valuations. The Federal Reserve reiterated at the end of the month that it does not
plan to adjust its balance sheet in the near term. After the release of minutes of the
FOMC’s December meeting stoked fear that the Fed might actually sell some of their
MBS holdings at some point, any action on this front now appears slightly farther off,
benefitting agency MBS collateral. While the market is awaiting a slew of regulatory
actions and decisions that may have far reaching effects on both the structure and
valuations in the agency MBS universe, for now powerful tailwinds on agency MBS
performance were enough to propel both relative and absolute valuations into
positive territory. The Bloomberg Barclays MBS Index ended January strongly, posting
positive excess returns of 32 basis points (bps) relative to benchmark U.S. Treasuries,
with total returns coming in at positive 79 bps in the month.
Coupon stack performance was generally positive across the board in January,
however both the lowest and highest coupons slightly outflanked production coupon
MBS. In Fannie Mae 30 yr (FNCL) collateral, FNCL 3s were the strongest performing
coupon, posting excess returns of 40 bps relative to benchmark U.S. Treasuries.
FNCL 3s benefitted from the Federal Reserve putting interest rate increases on hold, reducing the risk that increasing interest rates would cause
the coupon to become a deep discount coupon with no
production going forward. FNCL 3.5s and 4s were the laggards
in January, posting excess returns of 25 bps each. Interestingly,
higher coupons did slightly better, with FNCL 4.5s and 5s
coming in up 32 bps and 34 bps respectively. The story was
similar in Ginnie Mae MBS. 30 yr (G2SF) 3s led the charge,
coming in at positive 50 bps on the month. Higher coupon
Ginnie Mae MBS performed admirably as well. G2SF 4.5s and
5s posted excess returns of 31 bps and 44 bps respectively.
Higher coupon G2SF benefitted from continuing efforts by
regulators to reduce prepayment speeds on up-in-coupon
Ginnie Mae collateral. The servicer loanDepot was suspended
from Ginnie multi-pooling for six months, after Ginnie Mae
determined that its prepayment speeds were coming in faster
than tolerance levels. The removal of loanDepot at the end
of the month marked the first servicer to be removed since
former Ginnie Mae President Michael Bright stepped down,
and shows that Ginnie Mae will continue to punish servicers
they believe are churning loans. While there is some reason
to doubt the efficacy of the particular tactic, the show of force
from Ginnie Mae benefitted higher coupon performance
because investors can take solace that efforts are being made
to reduce prepayments speeds in the collateral. Overall, intra
coupon stack performance remained relatively muted, with
minimal changes in interest rates and a market that is awaiting
information on a host of regulatory issues holding much of the
relative performance in check.
GSE Reform Update
Among the many regulatory issues before the market is the
fate of the two GSEs. Fannie Mae and Freddie Mac have been
under government conservatorship since the financial crisis
of 2008. In that time, market participants often wondered
whether any long-term resolution would be reached, however
little to no progress has been made. Thus, when the acting
director of the Federal Housing Finance Agency (FHFA) gave
a speech stating that the Trump administration was going to
release a plan to take the two GSEs out of conservatorship
in the near term and most likely without the aid of Congress,
a litany of questions was raised. Days later, the Trump
administration suggested it will also attempt to work with
Congress on a legislative resolution to the decade-long drama
over the GSE’s fate. However, what the solution looks like
remains very much in the air given the large-scale ramifications
of any changes. The major question the administration
must tackle is how to re-capitalize the two entities, each of
which has only $3bn of its own capital to draw from and is
required to sweep all profits to the U.S. Treasury as part of
the revised 2012 agreement with the FHFA. Allowing them
to retain their own earnings would be a start, however, it is
estimated they need to hold between $150bn and $200bn
against potential insurance losses. So merely allowing the
two entities to raise capital by themselves will not enable
them to come out of conservatorship quickly, which is the
administration’s preference. Therefore, the administration
may need to continue to extend the $200bn credit line from
the U.S. Treasury. This would enable the entities to operate
without the necessary capital buffer until retained earnings
can be accumulated. Given that this may be possible without
Congressional authorization, a regulatory action of this type is
a distinct possibility in the coming months.
The prospect of Fannie Mae and Freddie Mac coming out of
conservatorship raises the question of what a large scale GSE
reform would entail for the market. If the entities are simply
spun out and allowed to retain capital without any other
changes, the result would most likely be slightly positive for
Ginnie Mae collateral on a relative basis. The market reaction
would likely be muted though because the implicit guarantee
of Fannie Mae and Freddie Mac borders on explicit in the
aftermath of the financial crisis where neither entity was
allowed to fail. Therefore, spinning the GSEs out with minimal
other changes would likely draw only a small market reaction.
The more important change would come if Congress altered
the nature of the guarantee entirely. The various options
include, removing the implicit guarantee of the two GSEs,
explicitly guaranteeing securities issued by both entities,
or doing something in between. The first scenario seems
incredibly unlikely due to the litany of problems it would create,
and the very low appetite of Congress to make home loans
far more expensive for millions of Americans. Either explicitly
guaranteeing GSE MBS or just having Ginnie Mae wrap all the
securities of the GSEs to create the same effect is an actual
possibility. However, both guarantee proposals would almost
certainly require that the divided Congress agree to add a lot of
risk to the government balance sheet, which would be a tough
hill to climb politically. Finally, Congress could come up with
some in-between solution that allows either some or all the securities to be government guaranteed through a higher loan
rate, or by investors paying for an outright guarantee on any
securities the investor holds. While both have their potential
pitfalls, it is possible that if Congress chooses to finally tackle
GSE Reform in the next year or two, some type of guarantee
change could occur. Thus investors will need to remain
vigilant, because an alteration of this type could significantly
affect the valuations of both Ginnie Mae and GSE collateral,
providing little warning before markets react and adjust.
UMBS Update
The regulatory stories that dominated January were not limited
to changing Fed policy and GSE reform percolating once
again. The coming of UMBS continues to be on the forefront
of agency MBS investors’ minds. UMBS is the plan to replace
the TBA of Fannie Mae and Freddie Mac with a single TBA
contract going forward. The first UMBS delivery date is slated
for June of this year. However, the TBA is far from the only
part of the market impacted. Changing the payment delay of
Freddie Mac from 45 to 55 days requires all new securities
with Fannie Mae tickers to be issued for every Freddie Mac
pool in existence. Investors will also have the option of
converting from legacy Freddie Mac 45 day pools to the 55
day Freddie Mac securities that will have Fannie Mae tickers
and a fee that makes the value even. Furthermore, investors
will be able to create SUPERs, securities containing collateral
issued by either or both GSEs. The stated purpose of this
entire endeavor is to increase market liquidity. Secondarily,
there are undertones that GSE reform may be easier once the
two GSEs are more homogeneous. To that end, making the
GSEs mutually deliverable requires their prepayment speeds
to match in all cohorts, making it impossible for the two
GSEs to compete with each other on price, which was the
original purpose of having two separate GSEs rather than just
Fannie Mae. Unfortunately, the FHFA has still not finalized
the rule regarding how the FHFA will keep two competing
entities from having divergent prepayment speeds. The FHFA
also has not given guidance on how the two GSEs cross
guaranteeing the collateral of the other through SUPERs will
work, especially if they are out of conservatorship and back
to attempting to compete and maximize profits. These and
a myriad of other questions remain, as the entire industry
attempts to prep for a change that it is between mildly and
strongly opposed to. How the FHFA and market participants
choose to prepare for the coming changes, with just four
months until implementation, will be biggest logistical hurdle
the market has to clear in the first half of 2019. Furthermore,
the market will be seeking clarity and answers sooner rather
than later, given the shockingly short runway for this initiative
to get airborne and the litany of questions that still need to be
answered before implementation.
