August Agency MBS Market Update

Monthly Commentary

September 07, 2017

The ‘dog days of summer’ for markets typically arrive in August, characterized by light trading volumes and minimal market moving activity. The story for global risk markets was not far from the mark; the S&P 500 closed unchanged through the month on minimal volumes, and global risk markets held closely in stride. Contrasting global stock markets, agency MBS and U.S. Treasuries were far less subdued in August. U.S. Treasuries bull flattened during the month, as pervasively low inflation and flaring tensions between the developed world and North Korea sharpened appetites for government guaranteed securities. 10yr U.S. Treasuries came close to their year to date low in yields, dropping to 2.12% at month end, bumping interest rate volatility off of recent lows. Agency MBS relative valuations were unable to prevail against elevated volatility and further U.S. Treasury bull flattening of the yield curve. While prepayment risk remains low, lower driving interest rates are generally not conducive to higher relative agency MBS valuations. Furthermore, increasing volatility is rarely if ever constructive for mortgages. The result was valuations leaked wider relative to benchmark U.S. Treasuries in August, even as total returns were positive. The negative excess returns sent the agency MBS basis back out of positive territory for the year, with a slightly better carry profile failing to improve the outlook for mortgages. In total, Bloomberg Barclays MBS Index underperformed benchmark U.S. Treasuries by 12 basis points (bps) in August, sending year to date excess returns to negative 9bps.

The agency MBS coupon stack reversed a few of the key trends witnessed in July. Most notably, Ginnie Mae collateral once again underperformed conventional MBS securities after a brief respite the prior month. Lower interest rates were a part of the problem, as Ginnie Mae pools with a proclivity to prepay quickly typically perform better when interest rates are rising. Furthermore, the steadfast challenges to the sector that have plagued valuations all year remain. Namely, lack of foreign sponsorship in the face of reduced all in yields, the removal of potential regulatory tailwinds, and a difficult relative value proposition; continue to prove an impediment to the sector. Whether the Ginnie Mae space has bottomed after its troubling 2017 thus far remains to be seen, but the August results demonstrate that markets have not yet reached equilibrium between conventional MBS and Ginnie Mae collateral. A second trend that saw some late summer pushback was the rise of Freddie Mac (FGLMC) collateral relative to Fannie Mae (FNCL) MBS. Historically, FGLMC bonds trade behind their FNCL counterparts despite incredibly similar collateral characteristics, the result of less overall liquidity in pools and TBA securities. The planned completion of Single Security MBS in 2019 is designed to bring the two Government Sponsored Entities valuations in line with one and other. However, this summer FGLMC valuations surged passed their FNCL counterparts in many coupons. FGLMC/FNCL 3.5% swaps opened the month at positive 2.25 ticks, with other liquid coupons not far behind. Despite shorter payment delays that make FGLMC theoretically preferable to FNCL coupons, the historic liquidly discount wholly evaporating was a surprising turn of events. The month of August saw the trend reverse, with FGLMC/FNCL 3.5% swaps dropping back to 1 tick. The movement was seen across the coupon stack, bringing swaps more in line with historical norms. In 30yr FNCL collateral, there was slight outperformance by lower coupons, with FNCL 3s finishing with positive 8bps of relative excess returns, and FNCL 4s closing with negative 18bps of relative underperformance. Lower coupons benefitted from longer durations and declining mortgage rates that have buoyed the bottom of the coupon stack in 2017.

The major regulatory story in August was the announcement of a new program to allow homeowners to refinance high loan-to-value (LTV) mortgages in conjunction with yet another extension of the Home Affordable Refinance Program (HARP). HARP was designed to give borrowers the opportunity to refinance loans that were underwater due to the 2008 financial crisis. The theoretically temporary program has been extended numerous times over the last few years, as the Federal Housing Finance Agency (FHFA) worked to draw up a replacement program. Set to expire on September 30th of this year after the extension last fall, regulators had very little time remaining to announce and implement a new program. The initial announcement finally came at the end of the month, with regulators choosing to extend HARP once again until the end of 2018 while presenting an outline of the new program. Specifically, only loans originated after October of this year will be eligible for the new streamline refinance program, and borrowers looking to refinance using the program will need to have held their current mortgage for 15 months. The result is that high LTV borrowers in primary residences will not be eligible to refinance until January of 2019. The market was expecting a new program for newly issued high LTV loans, yet the details remain important. Specifically, the new program will increase the negative convexity of mortgages going forward, since homeowners will have more ability to refinance in the event home values decline. Furthermore, the extension of HARP until the end of 2018 negatively impacted a few remaining pools and derivatives, mostly higher coupon pools issued prior to the financial crisis. Ultimately, this does appear to be the final extension of the long-running HARP program, and the beginning of a more negatively convex agency MBS universe.

Prepayment speeds were once again benign during the month, as mortgage rates continue to hover well above lows seen in 2016. The result is the agency MBS universe remains largely free of extensive prepayment risk for now. FNCL speeds fell 7% overall, falling to 11.6 CPR for July. Across the 30yr coupon stack, CPRs dropped around 1 CPR. Higher coupon speeds fell more than expected, as HARP eligible pool prepayments continue to come in below street expectations. It appears fewer borrowers are taking advantage of the program, even as Harp was extended through next year. Prepayment curves also remain flat relative to historic norms. Specifically, FNCL 4s are only 2 CPR above FNCL 3.5s and FNCL 3.5s are only slightly outpacing the gap with FNCL 3s. Ginnie Mae collateral posted a decline of speeds of just 3% month over month, which contributed to the poor relative performance of government guaranteed collateral in August. Ultimately, the prepayment picture will need a major shakeup in the level of mortgage rates to cause a significant uptick in speeds. With 30yr mortgage rates suck inside a 35bp range year to date, it is unlikely major prepayment level changes will appear in the near term.


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