The Year of the Federal Reserve: Making Sense of 2009
A caveat before you start reading: when we read trade publications, our grains of salt are usually at the ready as we start to sift out the actual value of the commentary versus the obligatory embedded sales pitch. To save our time concocting hidden self-promotion, and your time looking out for it, we’ll just give you our top secret sales plan ahead of time: Share something educational that benefits the industry while keeping you, the audience, interested in the idea of reading more in the future. We’ll try to earn your money later, for now, we’ll just get to know each other a little better by discussing the state of the mortgage market and where we're going from here...
We’ve all read enough, heard enough, and experienced enough to know how we got here. Whether your personal understanding is informed by real life experience or by a satirical stick figure slide show, we can all agree that loan programs, funding lines, lenders themselves, and even the mighty GSE’s were destroyed or damaged at an unprecedented rate. We can all agree that loan funding sources were rapidly vanishing and the secondary mortgage market was near complete collapse. We can all agree that the mortgage market was in desperate need of liquidity—even resuscitation…
The Federal Reserve provided both on November 25, 2008.
from the Federal Reserve Press Release: " Purchases of up to $500 billion in MBS will be conducted by asset managers selected via a competitive process with a goal of beginning these purchases before year-end."
"Spreads of rates on GSE debt and on GSE-guaranteed mortgages have widened appreciably of late. This action is being taken to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally."
The primary outcome of the announcement: COLLAPSE PREVENTED.
Certainly the initial market reaction was a welcome change for the industry. Mortgage rates dropped to record lows, loan demand went through the roof, deserted office space filled up, despondent originators stepped off the ledge, and the “it that shall not be named” (REFI BOOM...sssssh) had finally arrived.
Although MBS prices did in fact create an unprecedented level of refi activity, unforeseen challenges would follow...
Among the most evident consequences of such a meteoric price appreciation was the rapid exhaustion of lender capacity. Preventive cost cutting measures in response to a previously low volume environment left operations departments working with essential staff only. The effects were obvious as turn times lengthened, lock extensions became more expensive, lock desks shut down early, and fallout became the new norm.
Aside from counterparty tensions running much higher and the loan process lengthening, another challenge contributed to a new source of confusion and frustration for the industry: The Primary/Secondary Spread was widening.
Consumers were hearing government officials and the media referring to mortgage rates in the 4% range. However, because lenders were now attempting to control the size of their pipeline via mortgage rate moderation, originators were unable to offer these rates to borrowers. As a result, many potential purchases and refinances didn’t make it to the closing table as consumers decided to hold out for lower rates.
Although this was a minor development in the primary mortgage market, the resulting consequences would contribute to a significant shift in the secondary market's supply/demand equation.
After the initial euphoria of Fed buying wore off in late January, the MBS current coupon bottomed out, mortgage rates started creeping into the 5.00s, new loan production moderated, and originators started to wonder if the “it that shall be named” (REFI BOOM..ssshhh!) had come and gone in an instant.
More importantly, an accurate read on the secondary market's bias towards new loan production MBS coupons was presented. The previously discussed lender capacity constraints had resulted in higher fall out, less closed loans, and therefore slower MBS prepayment speeds.
Prepayment speeds determine, to a great extent, the timing of principle cash flows back to the MBS investor. If forecasts of prepayment speeds are miscalculated, the value of an MBS holder’s portfolio can be drastically effected. The faster the prepayment rate, the quicker cash flows are paid back to the bond investor, and therefore the shorter the life of the fixed income investment. Conversely, when prepay speeds slow down, the average life of the bond's cash flows are extended. This occurs because of the embedded call option in mortgage-backed securities.
Plain and Simple: Only the borrower has the option to pay off their mortgage debt. If a borrower's mortgage rate is below current market yields, they will be less likely to refinance. If an investor buys a mortgage-backed security with cash flows supported by borrowers that have mortgage rates near current market, and rates unexpectedly rise, that investor will be holding an MBS that is unlikely to prepay because borrowers will have no incentive to refinance (because current market rates are higher). This is called extension risk.
Once MBS investors became aware of the operational limitations of lenders and its slowing effect on prepayment speeds, a portion of the mortgage buying community began to overlook the need to hedge prepayment risk. Money managers, hedge funds, and even banks slowly shifted their positions "up in coupon".
The downside of this bias: it subtracted from demand side support for "rate sheet influential" MBS coupons and forced the Federal Reserve to become the sole source of liquidity for mortgage originators looking to protect their pipelines from interest rate risk.
The Fed's role in the mortgage market had evolved into something it was not prepared to fulfill. On March 18,2009, the Federal Reserve solved that problem.
from the March 18, 2008 FOMC Statement:
"To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. "
In the months that followed the Federal Reserve's presence in the secondary mortgage market was glaringly obvious. The Mortgage Banker selling rate on new production coupons averaged approximately $2 billon per day while the Fed's official buyers averaged $5 billion bonds purchased per day. MBS prices hit new all time highs and mortgage rates reached new record lows. Status quo had been restored in the golden era of mortgage rates, this was indeed the second phase of “it that shall not be named.” (REFI BOOM...ssshhh!)
But summer brought an unfriendly development for mortgage rates. Government stimulus packages were filtering through the economy and the Fed's balance sheet expansion was freeing up credit in the banking system. "Better than expected" economic data became an ongoing trend, talking heads were discussing "green shoots", and an ongoing stock market rally was adding energy to the idea of a V-shaped recovery. Markets were seeing the best evidence for a bottom since the recession began.
Optimistic economic outlooks led to the progressive unwinding of risk averse positions in Treasuries. As market participants exited their "flight to safety" trades, benchmark yields rose. Normally this would have negative effects on MBS prices, however the Fed's intervention in the secondary market sheltered the MBS coupon stack from yield curve steepening and kept mortgage rates from rising. Unfortunately it distorted the value of mortgage related bonds in the process. Relative to benchmarks, mortgages were priced far too rich. Combine that with a traditionally bear-biased season for bonds and the ingredients were there for a major correction...and it happened in a hurry.
May 27, 2009. BLACK WEDNESDAY: a day when "rate sheet influential" MBS coupons were sold by banks, servicers, pension funds, money managers, insurance companies, and hedge funds. Over $10bn in MBS coupons were offloaded from portfolios, an amount not even the Federal Reserve could stand up to. MBS prices plummeted and lenders re-priced for the worse two and three times, pushing mortgage rates to the highest levels of the year.
Originators were dejected and borrowers bewildered. The second phase of "it that shall not be named" (REFI BOOM...ssshhh!) had come to an end in just one trading session.
As summer progressed, "green shoots" theories died down and bond yields fell as uncertain economic outlooks re-emerged in the marketplace. Eventually the MBS current coupon leveled out in the mid-4s, mortgage rates stabilized near 5.00%, but there was never a third stage of "it that shall not be named" (REFI BOOM...ssshhh!).
For mortgages, 2009 has been the year of the Fed. If you’ve originated, processed, underwritten, closed, shipped, sold, purchased, packaged, or securitized a mortgage in 2009….there is a high likelihood that the Federal Reserve purchased your loan. This leads us to a question many are asking...
WHAT HAPPENS WHEN THE FED EXITS THE SECONDARY MORTGAGE MARKET?
The Federal Reserve will gradually withdraw from the secondary mortgage market, slowly waning us off their support.
Subtracting the Federal Reserve's bid will likely back yield spreads out 10 to 15 basis points and increase mortgage rates 40-70 basis points. However, as some form of liquidity backstop will likely be created or re-established (GSEs) to fortify the overseas appetite for AAA yields, the mortgage market will still offer the highest and safest return on principle worldwide. Mortgage securitization will live on....
Adam Quinones is Managing Editor of Mortgage News Daily and co-founder of the MBS War Room. Matt Graham is the creator of the MBS War Room, a first of its kind service bringing institutional quality market data and analysis to mortgage market professionals. Matt and Adam's intraday MBS market commentary can be found on MortgageNewsDaily.com