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.

SoberLook.com

From our sponsor:

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.

SoberLook.com

From our sponsor:

Freddie Mac takes the first step in transferring mortgage default risk to the private sector

NY Times: - In an appearance in Phoenix, Mr. Obama will endorse bipartisan efforts in the Senate to wind down the two companies and end their longtime implicit guarantee of a federal government bailout. That dread prospect, once thought improbable, was realized in the fall 2008 financial crisis; Fannie Mae and Freddie Mac, then bankrupt, were made conservators of the government at great cost to taxpayers, who only now are being repaid.

The president, according to administration officials, will make clear that he will only sign into law a measure that puts private investors primarily at risk for the two companies, which buy and guarantee many mortgages from banks to provide a continuing stream of money for lenders to provide to additional home buyers.

"Wind down the two companies and end their longtime implicit guarantee" is a hell of an undertaking, considering that transferring these agencies into private hands did not work so well the last time. What about simply getting rid of them?  The problem is that the US banking system simply can not absorb the mortgage loan volumes currently generated in the US. And with the new Dodd Frank-based capital constraints on banks, adding massive mortgage portfolios to their balance sheets will be even more difficult. The only way to reduce this reliance on the federal government is to involve private investors in underwriting mortgage credit risk.

Currently the bulk of the default risk on mortgages is borne by the taxpayer (via Fannie, Freddie, FHA, etc.). Investors only assume the mortgage prepayment risk - via agency MBS securities (although they effectively pay the government some fees to take mortgage default risk). Do investors have any appetite for a security that allows them to take on credit risk as well - and get compensated in the process?

Prior to the financial crisis, the non-agency MBS business was fairly active. However given the artificially low mortgage rates (driven by implicit government guarantees for the GSEs and their low funding cost), the only way investors could make money was in the non-traditional mortgage space (sub-prime, Alt-A, etc.) - with the help from the rating agencies of course. We all know how that turned out. As a result, the non-agency residential securitization business has virtually disappeared, leaving the responsibility for such securitization (and risk) to the taxpayer - see charts below for illustration.

Source: SIFMA

Now, under pressure from the federal government, Freddie Mac is trying out an experiment. The goal is to create a security to allow investors to take on mortgage default risk. The current structure (shown below) is offering subordinated first-loss tranches with no principal guarantees. Defaults are defined as 180+ day delinquency or short-sale, REO sale, etc. Once there is an event of default, the investor's principal is reduced by a predefined amount (severity). Effectively Freddie is buying a CDS protection on a tranche of its portfolio from investors at a predetermined recovery level. The investor knows exactly what the losses will be based purely on the number of defaults - which is easier to project and model. Only class M1 and M2 (below) will be sold to investors - although Freddie would probably love to sell the B-H (equity tranche) as well.

Freddie Mac: -

• One of the industry’s largest and most diversified reference pools
  
• Freddie Mac holds the senior risk, which is unfunded and not issued
  
• Senior mezzanine and junior mezzanine notes, which are not guaranteed by Freddie Mac, are sold to investors 
• Freddie Mac may retain a first-loss piece
• STACR notes have a 10-year final maturity
• The notes are paid monthly principal similar to a senior/subordinate, private label residential mortgage backed securities structure
• Losses based on credit events in the reference pool are allocated to the Notes in reverse order of seniority, and reduce the balance of such Notes

Source: Freddie Mac

If this works, it will be an important first step in getting private investors engaged in this business. It will also create price discovery to allow the agencies to properly price the so-called guarantee fee (the insurance premium the agencies charge for MBS principal protection).

Barclays Research: - This structure protects the taxpayer from certain risks by transferring them to the private market, provides the GSEs a way to achieve true risk-based pricing of the guarantee fee and is likely to be appealing to a range of political camps. Importantly, it achieves all of these without affecting the agency MBS market.

Pulling the government "guarantee" plug from the GSEs at this stage will destroy the housing market - potentially plunging the nation into another recession. To do it gradually however will take years in order for the private sector to absorb some of this risk - potentially using structures like these for a portion of it. It's not clear how large such a program can get, particularly if house price appreciation slows. It is however a certainty that the more of the mortgage risk is shifted to the private sector, the higher the mortgage rates will get.

Furthermore, if the guarantee fees become linked to the pricing of such securities, the mortgage market will become highly procyclical. When investors become concerned about the housing market, mortgage rates will rise (due to higher cost of the guarantee), putting more downward pressure on the housing market and so on, potentially temporarily freezing the mortgage market altogether.

These are enormous challenges to overcome and there is quite a bit of skepticism about the new proposal from the Obama administration. Nevertheless, this Freddie Mac structure (which got very little press so far) is the first step.


Enjoy!

STACR

SoberLook.com

From our sponsor:

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.

SoberLook.com

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.

SoberLook.com

Freddie Mac's "inverse floater" allowed more loan origination

Everybody is up in arms today about the Propublica story discussing Freddie Mac "betting against the borrowers" (hat tip Mike Konczal). The structured securities Freddie holds tend to be the "interest-only" component of a pool of mortgages. As long as borrowers in the pool keep paying, the holder of these securities receives cash. The more borrowers refinance, the less interest income is left in the pool. A holder of these securities therefore does not want borrowers to refinance and instead just keep paying as long as possible. How diabolical!

NPR: “We were actually shocked they did this,” says Scott Simon, who as the head of the giant bond fund PIMCO’s mortgage-backed securities team is one of the world’s biggest mortgage bond traders. “It seemed so out of line with their mission.”

And more...

Daniel Fisher (Forbes): ... I don’t get it. Freddie Mac did something potentially risky, but it was based on the reasonable assumption that interest rates can’t go much lower, but neither will they rise dramatically. According to the ProPublica story, Freddie bought $3.4 billion in “inverse floaters,” which are mortgage-backed bonds based on the interest payments from homeowners. As ProPublica points out, those securities can lose value when homeowners refinance or “prepay” in mortgage-banking terms. When that happens, investors get the principal portion of the mortgage back to reinvest but the stream of interest payments ends forever.

Freddie holds a massive portfolio of mortgages. Many of these borrowers have negative equity, can't refinance, and therefore pay higher coupon. Freddie can leverage that excess coupon stream via the interest-only securities and generate extra revenue with little capital.

Freddie holds both floaters and inverse floaters (much larger book of inverse floaters than floaters.)  Both are interest-only securities, but inverse floaters tend to be more stable. As rates rise, the coupon decreases, but there is more cash available to pay the coupon because prepayments stop.

With rising rates, Freddie's big mortgage portfolio will fall in value because mortgage durations will extend, paying lower than market coupon (negative convexity). Interest-only securities would do reasonably well because any remaining refinancing in the pool of mortgages will stop and the coupon revenue will extend. These positions therefore will be providing some offset to the mark to market losses in the main book in a rising rate environment. If rates keep rising however, the inverse floaters will indeed get hurt because they will receive an increasingly lower portion of the interest pool. But typically mortgage portfolio managers use interest rate swaps to offset some of that risk.

In a falling rate environment the coupon in the interest-only pool will be reduced due to some prepay, but a big chunk will keep paying because of the borrowers' inability to refinance. The interest-only securities will drop in value but still be reasonably stable, particularly the inverse floaters. Freddie's main mortgage portfolio on the other hand should go up in value because it will be paying above market rates with refinancing speeds contained.

What happens however if the Obama administration launches some sort of a mortgage principal forgiveness program? The probability of this event is remote because many of these troubled borrowers also have home equity loans. It would be legally difficult to force a principal reduction on the "1st lien" mortgages, while "2nd lien" (home equity - often with a different lender) is still outstanding (hat tip Greg Merrill). 2nd lien loans will therefore have to be sorted out before such a program can be effective (and legal). Even if it does happen, it will definitely hurt the interest-only paper, but should be net positive for their main mortgage portfolio because it will reduce default rates.

It is also important to note that Freddie retained many of these positions from the secularization transactions in which it sold pools of mortgages. Often there simply weren't many "natural" investors in inverse floaters. But this securitization process gave Freddie more balance sheet to originate new loans.

Securitization of mortgage pools ("Gold Collateral" refers to pools of mortgages in Freddie's deals called Gold MACS)

It is true that Freddie has a responsibility to the mortgage borrowers. However it has a bigger responsibility to the tax payers who own the organization. And that responsibility includes managing the portfolio risk as a fiduciary. The interest-only securities are not hurting the borrowers, yet they capture some of the revenue back to the taxpayer. According to CBO, the US Treasury spent some $300 billion to prop up the GSEs. Shouldn't the taxpayers have the right to get some of this money back?

SoberLook.com

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
SoberLook.com

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.

SoberLook.com

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.