The shrinking MBS market

As discussed earlier, the supply of mortgage-backed securities (MBS) continues to fall behind the potential demand - even with the Fed's taper in place. New issuance has steadily declined over the past year, with the Fed becoming an increasingly larger proportion of that market.

Source: SIFMA

Mortgage Daily: - For nine straight months, agency issuance of mortgage-backed securities has moved lower -- though there was an uptick at the Government National Mortgage Association. Securitization volume now stands at its lowest level in more than two-and-a-half years.

Combined issuance of fixed-rate MBS at the Federal National Mortgage Association, the Federal Home Loan Mortgage Corp. and Ginnie Mae totaled 7 percent less in January than in December.

Securitizations have been lower each month since April 2013, has fallen by more than half compared to January 2013 and was the lowest since July 2011.

At the same time the Fed is to continue purchasing large amounts of this paper through the end of the year, albeit at a slower pace.

Some of the decline in new issuance has been due to the drop in mortgage refinancing - old securities don't amortize as quickly and fewer new securities are issued. But part of the reason for the lower volume of these securities remains the supply of mortgage loans. The total mortgage debt outstanding is barely growing - with a great deal of that growth coming from multi-family residence (apartment) financing.

Source: FRB

As a consequence, MBS paper outstanding has been shrinking since the peak reached back in 2007.

Source: SIFMA (includes CMBS)

Some of that of course is due to the collapse in private label MBS market, including sub-prime. But the amount of agency (government-backed) MBS has not grown much either.

While some would say that $9 trillion of MBS paper should be sufficient, one has to keep in mind that the US and the global economy is now substantially larger than it was in 2007. MBS, particularly agency bonds, are becoming a smaller portion of the overall capital markets, worsening the shortage of higher quality bonds (see story). Liquidity in that market has also suffered, with average daily trading volumes at the lowest levels in nearly a decade (see chart). These are some of the reasons the Fed should return the MBS market to the private sector by exiting its purchases as soon as possible.

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Key trends in US mortgage markets

The recent increase in long-term rates is causing major changes in the mortgage markets. Here are some key trends:

1. Refinancing activity continued to decline through Q3. The proportion of mortgage applications for purchase vs. refi has doubled this year (and that's not because of higher demand for homes).

Source: DB

2. A number of lenders who focused on mortgage refinancing such as US Bank, Provident Funding, and Flagstar are struggling (although the largest banks such as Chase and Wells seem to be less affected). This may result in an increase in the number of riskier mortgages.

DB: - Lenders who specialized in refinancing transactions have experienced dramatic loss of market share and either will have to become more competitive on rates in growth sectors such as ARMs to regain market share or loosen credit standards.

3. While a larger number of buyers now prefer ARMs, the dynamic within the fixed rate universe is a greater demand for 30-year mortgages vs. 20 or 15. That's because the monthly payments on 30-year mortgages are lower (slower principal repayment) and buyers are looking for the cheapest solution.

DB: - As interest rates have risen and volume has dropped, the product mix has shifted sharply ...  30-year mortgages are much more popular with homebuyers—more than 50% of 30-year mortgages are used for purchase transactions but less than 20% of shorter-term mortgages. As a consequence, the share of 15-year mortgages fell from 20% in September to 17% in October as the share of 30-year lending rose to 63% from 59%. Meanwhile, the ARM share has doubled to more than 5% since June as HARP’s share of lending has fallen to 3% from a high of 7% this spring.

4. As a result, MBS bond markets are taking a hit in the form of lower volumes. The sharp decline in refinancing activity has reduced the need to issue new agency mortgage bonds. New issuance is the lowest in years.

Source: SIFMA (note: this includes CMBS but the bulk of the activity is agency MBS)

Similarly, trading volumes in MBS have dropped off to new lows.

Source: SIFMA

Here is a summary on US mortgage markets from Freddie Mac (who, just as Fannie Mae, has been issuing fewer bonds):

Frank Nothaft, Freddie Mac Chief Economist: - With the close of 2013 will also come a major transition in the housing finance industry. For the first time since 2000, we're going to see the mortgage market dominated by purchase activity as the refinance share drops below 50 percent. And with mortgage rates rising, we're also going to see the home-sales gains as well as the impressive house price growth begin to moderate to more sustainable levels.

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Agency MBS market will be shrinking rapidly

The chart below shows fixed rate agency MBS issuance since the financial crisis. With the Fed taking out some half of this gross issuance (see post), one would think there should be paper left for other investors, right?

Source: JPMorgan

Wrong. The net (vs. the gross) issuance of fixed rate agency MBS has actually been negative. That's in part because the GSEs are shrinking their balance sheets. In fact they've been told to start shrinking mortgage portfolios by 15% a year (see discussion). The GSEs issue new bonds slower than the old bonds amortize due to mortgage prepayments, producing a negative net.

Source: JPMorgan

As agency bond issuance declines, the Fed purchases are picking up (locking these securities away - probably to maturity). The amount of MBS bonds in the market will begin contracting rapidly going forward.

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US Treasury shrinking the GSEs, capping taxpayer support

The US Treasury has restructured its holdings in the GSEs with the ultimate goal of shrinking the US government's dominant role in the mortgage market. Fannie Mae and Freddie Mac were told that they will be required to shrink their mortgage programs by 15 (rather than 10) percent annually. And rather than paying a fixed (10%) dividend to the government as they have in the past, the agencies will simply turn over all their profits back to the US Treasury (based on US government's 80% stake).

Bloomberg: - The mortgage companies, which have drawn $190 billion in aid and paid $46 billion in dividends since being taken over by U.S. regulators in 2008, will turn over any quarterly profits to the Treasury, the agency said today. The change replaces a requirement that the companies pay quarterly dividends of 10 percent on the government’s nearly 80 percent stake.

Fannie Mae, based in Washington, and Freddie Mac (FMCC) of McLean, Virginia, also will be required to shrink their investments in mortgages and mortgage-backed securities by 15 percent annually, up from 10 percent, the Treasury said.

“We are taking the next step toward responsibly winding down Fannie Mae and Freddie Mac, while continuing to support the necessary process of repair and recovery in the housing market,” Michael Stegman, counselor to the secretary of the Treasury for housing finance policy, said in the statement.

The privately held FNMA preferred shares collapsed on the news because there will be no funds left for private investors. All the profits go to the US government and growth will be negative due to the declining mortgage portfolio holdings.

Fannie Mae’s 8.25 percent preferred perpetual shares

One of the reasons to change the fixed 10% dividend to simply paying out all the earnings is to make sure that the GSEs do not run into cash problems. This way they will have the ability to pay out on their bonds even if their profitability drops. After Jan 1 the government support for the agencies is capped.

Bloomberg: - One motivation for the change was Treasury’s concern that investors would be skittish about buying GSE bonds after Jan. 1, when a ceiling on government support for the companies kicks in, according to a banker who discussed the policy with Treasury officials. Each company will be limited after that to no more than $200 billion in taxpayer support.

Many borrowers still don't fully appreciate that the reason they are able to obtain these ridiculously low mortgage rates has to do with the cheap financing the GSEs are getting by issuing agency securities. Without the government support, the mortgage market would be smaller and more expensive. Given the pressure to unwind the GSEs, the government's support for the mortgage market is likely to decline over time - and with it will go the low mortgage rates.

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US mortgage refinancing activity going strong - for those who are eligible

As the US mortgage rates continue to decline to new record lows, the refinancing activity for those who are eligible has been quite robust. Just when borrowers sign the papers for a new mortgage (particularly in situations when the bank covers the closing fees), they are ready to refinance again. Some households have done this more than once this year alone.

Source: Bankrate.com

You can see the refinancing wave by just looking at the weighted average life (WAL) of FNMA 30-year securities (Agency MBS). The shorter the average life, the more refinancing is taking place (if everybody in the pool refinances a year after getting their mortgage, WAL would be one year). Here is what WAL looked like in March for different coupon FNMA bonds.

March 20th, 2012

And here is what it looks like now. The 3% and the 3.5% coupon FNMA securities (roughly corresponding to 3.6% - 4.1% mortgage rates) WAL decreased by some 2 years in a short span of time. Note that the high coupon securities represent mostly pools of borrowers (who borrowed at higher rates some years back) that can't refinance because their mortgages are "under water" (low to negative equity). And the WAL declines in that part of the curve are barely visible.

July 10th, 2012

Mortgage applications for refinancing continue to stay strong as well.

Mortgage Applications for Refinancing - 4-week moving average

So far all this refinancing has not translated into material improvements in consumer spending, as savings from reduced mortgage payments simply help households further reduce leverage.

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The "robo-signing" settlement's impact on the mortgage market

Tonight is the State of the Union Address and rumors are circulating that Obama will announce the robo-signing settlement with the big banks. The number thrown around is about $25 billion. The idea is to use these funds to help troubled homeowners avoid default via refinancing and/or principal forgiveness.

To see what this means in the context of the overall mortgage market, let's perform an oversimplified calculation. Let's take someone who is currently paying 5.5% on her 30-year mortgage. Refinancing at current rates and paying 2 points as well as full fees would mean that within 3 years of refinancing the borrower will recover the fees and start saving. That basically implies that anyone with a mortgage rate materially above 5.5% should be refinancing if they can. Again for simplicity, let's take the full universe of FNMA 30-yr Fixed securities and look at the mortgage characteristics of the underlying pools of loans. The chart below shows the amount of loans outstanding vs. the average mortgage coupon (WAC) in the pools.

Again this is oversimplified, but the borrowers in the red portion of the chart (higher than our 5.5% example above) should be all refinancing as quickly as possible. The question is, are they refinancing?  The next chart shows the prepayment (refinancing) speed (PSA) over the past month vs. the average coupon.

The chart demonstrates that these homeowners are indeed refinancing but at a lower speed than the onses with a smaller coupon.  One would think the trend should be reversed - the higher the coupon the quicker people would want to refinance.  But that's not the case.  In fact fewer high coupon borrowers are able to refinance because those who could, already did.  The remaining homeowners are either really slow or just can't refinance because they have "negative equity" (mortgage principal higher than the value of their homes.).

Much of the refinancing is coming from the lower coupon borrowers, those with newer mortgages (since such low mortgage rates are a recent phenomena.)  The folks on the red part of the chart represent over half a trillion dollars in mortgages. And it doesn't mean that everyone with a 5.5% coupon can refinance either. This exercise just represents the FNMA conforming 30-year mortgages, which is only a part of the overall mortgage universe.

This simplistic calculation tells us just how ineffective the $25bn settlement would be. In fact only about 100,000 borrowers who could be helped with these funds because only some of the funds would go to the homeowners. However there are some 11 million borrowers with negative equity and need help.

So why bother, given this is such a drop in the bucket?  The answer is there may be a couple of potentially positive outcomes, though both are low probability events at this stage.

1. This settlement and the subsequent support for those few homeowners will give the government some idea of how effective partial principal forgiveness and lower rates are in reducing default rates and cutting overall losses for lenders/investors.  Currently this subject is debated. These statistics may pave the way for a much bigger government sponsored refinancing package (although it is not at all clear whether the taxpayer should be supporting such action).

2. The deal may accelerate the foreclosure process that has been put on hold by banks because of the "robo-signing" legal proceedings. Timely foreclosures are key to stabilizing the housing market because they move assets from weaker holders to stronger ones. A couple of million homes in foreclosure could come to the market quicker, reducing the overhang. This may delay the market recovery in terms of prices, but the recovery would be healthier when it does take place.

Many uncertainties in this deal still remain, such as numerous states deciding not to participate in the settlement. States may want to pursue their own litigation that could tie the banks up in court for a long time.  And that would delay foreclosures and make banks even less willing to provide new loans.

Either way, don't forget to tune in at 9 pm EST tonight and listen for the words "robo-signing".

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The Fed's profits

A NY Times (Dealbook) post today by Steve Davidoff compares the Fed to a hedge fund.

NY Times: I call the Fed a hedge fund because it is operating like one, leveraging its balance sheet to earn huge profits. The main difference between a hedge fund and the Fed is that the Fed effectively creates its own money, so it doesn’t have any borrowing costs, meaning yet more profits.

A couple of points on this:

1. The profits of this "hedge fund" flow directly to the taxpayer.

2. This government "hedge fund" is at least profitable, as opposed to say Fannie Mae and Freddie Mac, who also have very leveraged balance sheets and cheap government supported funding. According to CBO those other "hedge funds" cost the US taxpayer over $300 billion.

Hat tip Susan Menke
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Ginnie Mae and the government sponsored mortgage machine

A quick look at who is taking all the risk on new mortgages this year reveals some interesting facts. The chart below from the Fed shows some recent trends. Very few mortgage loans are kept on banks' balance sheets these days (Bank Portfolio) - and that fraction seems to be shrinking. The private securitization MBS market (Non-agency securitized) is also down to a trickle, though is a higher fraction than the balance sheet loans.

That leaves the US government to pick up the slack. It's not really a slack, it's the bulk of the new mortgage risk. The majority of these loans are of course extended through Fannie and Freddie. But there is a limit to how much these guys can take. The agencies are financing $5 trillion in U.S. mortgages already. It only takes a slightly higher than normal default rate to become under-capitalized on a $5 trillion balance sheet. The Treasury has so far injected over $100 billion of equity into the agencies to keep them afloat. That caps Fannie's and Freddie's ability to extend more credit.

To keep mortgages flowing however, the government has to pick up the rest directly by providing guarantees and sponsoring government insured MBS issuance. It does it through Ginnie Mae. That's why Ginnie Mae's proportion of newly originated mortgages has exploded.



Source: San Francisco Fed


So what exactly is Ginnie Mae? It's a government agency that actually does not directly take significant mortgage risk. Instead it simply guarantees timely payments on mortgages that are issued or guaranteed by other government agencies. The mortgage pools Ginnie Mae guarantees are:

1. Insured by the Federal Housing Administration,
2. Guaranteed by the Department of Veterans Affairs,
3. Issued or guaranteed by the Department of Agriculture's Rural Housing Service,
4. Issued or guaranteed by the Department of Housing and Urban Development's Office of Public and Indian Housing.

So why the "double guarantee"? Ginnie Mae effectively provides the bridge financing on payments between the time a mortgage loan becomes delinquent and the time when one of the 4 agencies (above) actually makes the investor whole on the guarantee. This way if a mortgage misses a payment, Ginnie Mae makes it immediately, and then collects from the other agencies later. And it does so with a pool of loans that serves as collateral for the Ginnie Mae guaranteed MBS bonds.



source: Ginnie Mae


A Ginnie Mae MBS is effectively a US Treasury security, but issued by a different agency. This shows just how the US government has turned the whole mortgage market into a machine that it now dominates, with a number of it's tentacles participating in different aspects. The Treasury supports the agencies by funding their equity. The Fed buys their debt and the mortgage securities they issue. And to the extent Fannie and Freddie can't handle more lending, the government steps in with four other organizations and wraps up the whole present with the Ginnie Mae guarantee.

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Ed Pinto's testimony on FHA

Attached below is a recent House testimony from Ed Pinto (Fannie Mae's chief credit officer back in the 80s) pointing to a potential funding gap at the Federal Housing Administration (FHA). FHA is the government agency that (among other things) provides mortgage insurance to the lenders for home buyers who do not have sufficient downpayment. In some ways the agency also helped contribute to the housing bubble by helping homeowners leverage their home beyond what would be considered prudent.

Ed Pinto Testimony

Mr. Pinto's testimony points to a potential gap between the claims liabilities on insured mortgages and the Mutual Mortgage Insurance Fund set up to cover these liabilities. The chart below shows the historical levels (in billions of the fund) and if one was to believe Mr. Pinto, the fund will be significantly in the red in the near future.





That means a potential rescue from the tax payer (in addition to the continuous bleeding of the GSEs and the FDIC). Mr. Pinto's estimate of the rescue required is between $40 and $60. As a general comment, it is unsettling to see the current administration focusing on numerous other issues without at least an attempt to address this situation.

How can the housing market be stabilizing? $1.55 trillion of new government funds, that's how.

From agriculture to autos to insurance, the US government is throwing taxpayers' money at various industries. The largest beneficiary of the taxpayer's dollars by far however is the US housing sector.

In a recent post Economists jolted by housing data we discussed signs of stabilization in housing sales and prices. Given the dollars thrown at the problem, it shouldn't be a surprise.

New home sales:


A number of readers have sent e-mails with some highly negative reactions, arguing that it's all nonsense, a "temporary blip". It may not feel like a stabilization if you live in Merced, CA or El Centro, CA (given how much prices have run up in these places). But at the national level the government dollars are starting to have an impact. The amount of money spent by the federal government to support this market, particularly via conforming mortgages (those that Fannie and Freddie are allowed to buy), is unprecedented.

Let's take a sober look at the numbers. The US Treasury is continuing to prop up Fannie and Freddie as they bleed from being completely over-leveraged. The agencies are financing $5 trillion in U.S. mortgages. It only takes a slightly higher than normal default rate to become under-capitalized on a $5 trillion balance sheet. The Treasury has so far injected nearly $100 billion of equity into the agencies, $45.9 billion for Fannie Mae and $51.7 billion for Freddie Mac.

Of course Obama's "Making Home Affordable" program to modify nine million American mortgages is not helping the agencies. They are forced to purchase loans out of mortgage backed securities and take losses, while the Treasury (the taxpayer) is covering those losses by injecting more funds into the agencies.

But that's not all. The Fed has also purchased $200 billion of agency debt directly on it's balance sheet. And to top it all off, the Fed has bought $1.25 trillion of mortgage backed securities, all as part of the "quantitative easing" program.

Add it all up to get $1.55 trillion to fund conforming mortgages by the US government alone. That doesn't even include all the TARP funds meant to get banks lending again. And some banks like Chase and Wells Fargo are in fact lending. It's hard to keep this massive bubble from completely deflating (as it would have on it's own), but throwing such resources at it is definitely keeping it from going flat - at least for the next few quarters.

And of course who could forget the Obama Administration "First-Time Homebuyer Tax Credit" of up to $8,000 per buyer. It expires on December 1, 2009 and should get some folks out there shopping for homes.

So when you see a pop in home sales, don't dismiss it as a temporary blip - it's the $1.55 trillion taking effect. Just remember people still need homes, and as long as the government's unprecedented support continues (to the point that it begins to feel like socialism), someone out there will be buying. At some point down the road the funds will stop flowing and some of this music may stop. But for now get that cheap conforming mortgage, use the tax credit and go buy a home.