LIBOR, the patch and an improved TBA

admin | December 13, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The bulk of relative return in agency MBS usually depends on probable changes to the basis and interest rates, all arguably priced into current spreads. But a few developments looks like possible sources of a little extra. The headlong transition to LIBOR looks likely to raise the risk premium on MBS with exposure to the index. The scheduled end of rules allowing Fannie Mae and Freddie Mac to buy loans with high debt-to-income ratios could shift supply and improve some pools’ convexity. And a net improvement in the quality of TBA could reshape opportunity in specified pools.

The rise of a LIBOR risk premium

The transition away from LIBOR looks set to keep going full speed next year and likely to create an increasing risk premium in LIBOR-indexed ARMs and CMO floaters and inverse floaters. The Federal Home Loan Banks this year, at the direction of their regulator, stopped investing in any MBS with LIBOR exposure beyond the end of 2021, when regulators expect banks to stop submitting LIBOR settings. The FHLBanks started leaning in this direction in mid-2018, and agency CMO floaters, where FHLBanks had invested heavily, have widened at least 20 bp from their tightest levels. Both the Fed and the SEC have warned banks and companies to account for LIBOR exposure. And Fannie Mae and Freddie Mac have stopped buying LIBOR ARMs seasoned more than six months and are working on a SOFR-based ARM. Even MBS that have sufficient language for transitioning to a new index embed some valuation risk. The year ahead is likely to see more focus on LIBOR exposure and less liquidity in LIBOR-indexed MBS. Look for an early exit from at least the floating side of LIBOR exposure—inverse-floater investors having few alternatives. Softness in LIBOR floaters could raise the implied costs of funds for inverse floaters.

The uncertain end of the QM patch

The agency MBS market looks likely to narrow the set of loans it securitizations in 2020, reducing supply of some pools and lifting the value and even improving the convexity of existing ones. One trigger is the January 10, 2021, expiration of rules that make any loan bought by Fannie Mae or Freddie Mac into a Qualified Mortgage, otherwise known as the GSE patch. The GSEs have used the rules to buy loans above the QM debt-to-income limit of 43%. High debt-to-income loans in 2019 have made up $229 billion or 25% of all new GSE production. The Consumer Financial Protection Bureau, which sets the rules, plans to let the rules expire, and Federal Housing Finance Director Mark Calabria supports it. The bureau could still extend the rules or modify the Qualified Mortgage definition to keep GSE funding open regardless of debt-to-income. If the rules did expire, borrowers could still get funding from the Federal Housing Administration or the Department of Veterans Affairs programs, or from portfolio lenders. But going from a GSE loan to something else would likely add cost, paperwork or other frictions, putting a drag on refinancing for current borrowers. The uncertain future of the rules and the hard deadline should push up the bid for pools currently backed by high debt-to-income borrowers, especially borrowers with high loan-to-value ratios that finance company and portfolio lenders might avoid. My colleague, Chris Helwig, also thinks the GSEs could raise the cost of guaranteeing investor loans and cash-out refinancings as the Federal Housing Finance Agency tries to slowly shrink the GSE footprint. Outstanding pools backed by high debt-to-income borrowers get the investor long an inexpensive option on a bumpy end to the GSE patch.

A net improvement in the convexity of TBA

The quality of the TBA deliverable should improve in 2020, broadly adding to the relative value of agency MBS while softening the relative value of specified pools. Pools created in late 2018 with extremely high gross WACs hurt the value of TBA this year, but those pools have already lowered their WAC through prepayments and accumulated some burnout. The steps taken last June to cap the WAC on new pools and the accumulating volume of these pools should have a growing influence on the TBA deliverable. This should improve TBA pricing, and, consequently, soften the value of specified pools. Investors should look to lighten up on the richer parts of the specified market.

The biggest caveat to improvement in TBA is the recent jump in the regular conventional conforming loan limit from $484,350 to $510,400, and the move in the large loan limit from $726,525 to $765,600. Servicers have more room next year to securitize larger loans and consequently erode the convexity of TBA. On balance, limits on WAC should outweigh the impact of larger average loan balances.

The underlying consensus

Much of the remaining backdrop to the agency MBS market for next year is already largely priced into current spreads. The consensus on supply, demand and fundamental risk roughly falls out as follows:

Supply.

Net supply of agency MBS in 2020 looks likely to land around $300 billion thanks to a mix of home price appreciation, housing turnover, new home sales and refinancing of portfolio and private loans into agency products. That should put new supply roughly even with 2019. Ginnie Mae’s 29% share of outstanding MBS and Freddie Mac’s 28% share both look likely to rise, as they have for the last few years, with Fannie Mae’s 43% share consequently falling. It’s worth noting that likely healthy net MBS supply compares with an expected $885 billion of net Treasury supply next year. All else equal, heavier Treasury supply argues for steadily tighter MBS-to-Treasury spreads.

Demand.

Demand for MBS has at least one weak hand: the Fed. And since the Fed is the second largest holder of agency MBS, Fed demand matters. The Fed intends to continue allowing its SOMA holdings of MBS to prepay and amortize and then reinvest in Treasury debt. Assuming rates follow the current implied forward path, that amounts to a nearly $260 billion MBS-for-Treasury trade. Banks, the largest holder of MBS, offer a mixed picture. Banks with assets between $100 billion and $700 have less regulatory need for MBS next year. New rules approved by regulators in October lighten requirements for those banks to hold high quality liquid assets, which include agency MBS and attach particular value to Ginnie Mae MBS. Allocation away from MBS would depend on opportunity and potential return in loans or other securities, but agency MBS has clearly lost regulatory value for these banks. Away from the absolute level of bank demand, the mix of demand should change. Conventional MBS should gain favor over Ginnie Mae MBS. And because the new rules also give banks more leeway to take interest rate risk, 30-year MBS should gain favor over 15-year. Demand from most other major MBS investors—notably, foreign portfolios, REITs, pensions and insurers—looks unlikely to make up for a shortfall at the Fed and banks. The GSE portfolios will probably tread water. That leaves only mutual funds with potential to absorb MBS, and tight spreads in corporate credit make that a possibility. All else equal, likely net demand for MBS argues for wider spreads.

Fundamentals.

Rates, volatility and prepayments cover the fundamentals for agency MBS, and the market is pricing for relatively low rates, a flat yield curve and low volatility. The default assumption for prepayments is that turnover and refinancing in 2020 will reflect prepayments over the wide range of rates in 2019. There is room for surprise, however, highlighted in our 2020 rates outlook. The risk runs to rates that dip substantially lower than forward curves now imply and episodes of volatility that run higher than the options market now implies. That would broadly hurt MBS performance and add to the value convexity, whether in MBS or any other product.