February Agency MBS Update

Monthly Commentary

March 02, 2016

February proved a worthy successor to January in global risk markets, as the fear that characterized the first month of 2016 continued to percolate. The agency MBS basis once again widened, driven by lower treasury rates and continued stress in fixed income risk assets. While oil prices and the stock market mostly managed to hold up under the continuous stress of global news, rapidly decelerating global inflation expectations drove the spread between agency MBS and benchmark U.S. Treasuries wider. A lower than expected non-farm payroll report (+151k vs. 190k expected) did little to alter the belief among many investors that the U.S. economy is slowing. Fear of a European slowdown hit the markets in rapid succession, causing a sustained rally in U.S. Treasuries, as yields dropped to the lowest level since January of 2015 (10yr at 1.66%). The lower interest rates raised the specter of a coming prepayment waive should these levels be sustained. Falling mortgage rates furthered this fear, which coupled with a rising Refinance Index presented a conundrum to agency MBS investors. How long will lower rates be sustained and to what level will prepayment rates escalate should lower borrowing rates persist? The risk inherent in these questions drove the agency MBS basis materially wider mid-month. Just as hints began to emerge that global risk assets might be parrying their losses as February wrapped up, stagnant volatility picked up. The result was agency MBS relative valuations increasing only slightly at month end. Thus, February turned into a second consecutive month of underperformance for the agency MBS basis to begin 2016. In aggregate, the Barclays MBS Index posted returns of negative 14 basis points relative to U.S. Treasuries, dropping the relative performance since the new year to -53 bps.

The performance details of the agency MBS universe in February showed poor performance across most of the agency MBS universe. In Fannie Mae 30yr (FNCL) MBS, the middle of the coupon stack struggled the most relative to their 10yr U.S. Treasury hedges (HRs). The pain was felt primarily in FNCL 3.5s and FNCL 4s, which underperformed HRs by 18+ and 15+ ticks, respectively. Investors eschewed coupons that were most likely to be affected by a potential refinance wave that could materialize with driving mortgage rates under 4%. Higher coupons outperformed in February, as many are already well in the money for borrowers and thus it is unlikely speeds will increase significantly in spite of lower mortgage rates. FNCI collateral struggled, as faster than expected speeds combined with investors demonstrating less willingness to pay for extension protection. The news was similarly bleak in Ginnie Mae (G2SF) collateral. The entire stack saw investors running for cover, as lower rates hurt G2SF relative valuations, and faster than expected prepayments caused further consternation. The poor performance was evident throughout the coupon stack; G2SF 3.5s underperformed their 10yr HRs by 17+, while G2SF 4.5s struggled, closing down 19 ticks. The G2/FN 3.5 swap did close up a tick, although not without some volatility, dropping 5 ticks early in the month only to recover into Leap Day. Finally in rolls, the continuing story is the weakness in rolls throughout the coupon stack. With prepays seemingly ready to accelerate, rolls have struggled as more agile investors have continued to move into specified pools. Heading to March, whether rolls continue their decline and how the coupon stack reacts to lower interest rates will be key factors influencing mortgage valuations.

The January prepayment report demonstrated that even slower speeds could not reverse the difficulty in valuations across the coupon stack. Fannie Mae (FN) speeds dropped 23% in January, dropping from 12.4 CRP (Dec) to 9.5 CRP (Jan). The day count fell by three in January (22 to 19), with slightly higher driving rates helping to temper speeds. While FN 30yr speed declines were largely in line with expectations, one notable exception was the 2014 FN 3.5 cohort that dropped 37% in January. The surprise falls in contrast to the Freddie Mac (FG) 2014 3.5s that actually sped up. In contrast, most FG coupons were largely in line with their FN counterparts. In 15-year collateral, FNCI speeds came in faster than expected with overall speeds falling 18%. The speed upside surprises were primarily in recent cohorts, acting in contrast to conventional 30yr fixed rate loans. Ginnie Mae collateral speeds came in faster than expectations as well, with G2 collateral only seeing a decline of 15% versus December. Speeds fell primarily in lower coupons, with G2 3s falling 19% while G2 4.5s only fell by 11%. In aggregate, the faster than expected speeds did not have too great of an impact on the relative performance across the stack, however if lower coupons continue to see speeds decline more than their higher coupon counterparts in G2 pools, that will be of importance. Ultimately, prepays were not so far from expectations as to have much influence on valuations in the month of February.

The ever churning wheel of regulatory intrigue continued unabated in February. This month the director of Federal Housing Finance Agency, Mel Watt, gave a much anticipated address on the two Government sponsored entities (GSEs) that have been under government conservatorship since the 2008 financial crisis. The address was wide ranging, but the most notable comment Mel Watt made was on the lack of capital at Fannie Mae and Freddie Mac. When the two GSEs entered conservatorship during the financial crisis, part of the amended agreement was that all profits earned by the two entities would go to the U.S. Treasury. As the economy has recovered this has created a windfall of some $50 billion to U.S. Government coffers. The challenge presented by profits being swept directly to the U.S. Treasury is that Fannie Mae and Freddie Mac have not had the opportunity use any of that money to create a capital buffer in case there is another housing downturn. Furthermore, the capital buffer is mandated to go to zero by 2018. To that point, Mr. Watt stated that, “The most serious risk and the one that has the most potential for escalating in the future is the Enterprises’ lack of capital.” The reason that this risk is so paramount is neither entity is prepared for potential negative events in the same manner as U.S. banks are. As GSE capital continues to diminish, it becomes increasingly likely that a negative turn of events could force Fannie Mae or Freddie Mac to draw funds from the U.S. Treasury. This could have negative market and political repercussions should the problem not be addressed. While this challenge is not one that is likely to be dealt with during an election year, hopefully there can be a resolution prior to a crisis where there might not be the time, opportunity, or willpower for a comprehensive solution.

Looking to March, it will be important that risk assets find more solid footing, or for interest rates to back up, to get some positive momentum in agency MBS. Prepayment speeds will likely be slightly higher on the back of the day count increasing and driving rates dropping slightly. Furthermore, regulatory overhang will continue for the foreseeable future. Regardless of the outcome, given the opening of the 2016 year in markets, there is no reason to believe that the agency MBS performance will be without volatility again in March, or for that matter the rest of the calendar year.

FNMA Current Coupon Nominal Spread vs. UST 5s/10s Blend

Source: Barclays, Bloomberg

Conventional 30yr Primary Mortgage Rate – Production

Source: Barclays

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