Lessons learned in agency MBS in 2021

Brian Landy, CFA | December 17, 2021

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 last year brought plenty of regulatory changes to agency MBS, although many were later suspended. Liquidity and capital constraints prevented non-bank lenders from taking full advantage of opportunities with delinquent Ginnie Mae loans. Prepayment speeds, although slowing, still were able to surprise to the upside. Models struggled. And historically fast home price appreciation caught everyone by surprise. Each of these have lessons for the MBS market in 2022.

#1 Capital and liquidity constrain non-banks

Non-bank servicers proved largely unable to take full advantage of their option in 2021 to buy out delinquent loans from Ginnie Mae pools. Ginnie Mae allows servicers to buy out loans at par once they have reached 90 days delinquent. Servicers could earn hefty returns by re-pooling loans that cure without a loan modification, since those loans would likely command a premium above par. Ginnie Mae took steps to reduce the liquidity of the re-pooled loans, and the result has been much slower buyouts by non-bank lenders than bank lenders. Most non-bank lenders face capital and liquidity constraints and cannot risk owning loans they can’t get off their balance sheets quickly. Banks, however, have a low cost of funds and were able to buyout most delinquent loans. Non-bank lenders originate nearly 80% of all loans, and almost 90% of all Ginnie Mae loans, so capital and liquidity concerns will continue to play a large role in mortgage markets in 2022.

#2 Regulatory changes are hard to predict

Fannie Mae and Freddie Mac rode a bumpy regulatory road in 2021. The outgoing administration surprised markets in January with amendments to the Preferred Stock Purchase Agreements (PSPAs) that severely constrained some of the GSEs’ operations. In particular, the amendments limited the GSEs purchases of investor loans and required them to limit their cash window purchase. And to comply with the changes, the GSEs needed to adjust operations in advance of the deadlines, which was even more disruptive to markets. However, in June the Supreme Court ruled that the president can fire the director of the Federal Housing Finance Agency at will. President Biden did just that, and in August the amendments were suspended for review. But not all changes had a big effect on markets. Initiatives like the GSEs’ RefiNow and Refi Possible programs and the FHA’s Advance Loan Modification worried investors but ultimately were of little consequence.

Going forward, regulatory risk is increasing because the current administration favors a larger role for government lending. The bigger the role, the bigger the risk of change. Fortunately for investors, current regulators appear committed to responsible management, and that should help moderate changes. But the next time the presidency changes hands or changes priorities, there is a greater chance of a big change in policy. The FHFA director has less power to insulate the GSEs from political shifts, especially if the presidency changes parties.

#3 The challenges of modeling prepayments

Predicting prepayments during the pandemic has been difficult. Most models failed to capture the large jump in speeds in 2020, and the difficulty continued throughout 2021. A major problem was identifying the prevailing mortgage rate. Various mortgage rate surveys overstated rates throughout 2020 and into 2021, and models consequently forecast speeds that were too slow.

Inaccurate mortgage rates were not the only driver of prepayment error. Greater efficiencies in the appraisal process—desktop appraisals for purchases and appraisal waivers for refinances and purchases—help lift prepayment speeds. But a big pickup in housing turnover also pushed prepayment speeds faster. And record low interest rates likely triggered a media effect. It will be challenging for models to assign the appropriate importance to each of these factors. Modeling turnover prepayment speeds is hard when most of the market is in-the-money to refinance. This raises the risk that models will continue to have difficulty forecasting prepayments.

#4 Home price appreciation was a huge surprise

Home prices grew much faster than expected in 2021, which suggests there could be considerable uncertainty with forecasts of home prices in 2022. A review of four projections for 2021, made near the start of the year, showed expectations that ranged from 2.1% to 5.3%. However, appreciation totaled around 14% for the first three quarters of the year, or more than 4.5% growth each quarter. The HPA in each quarter of 2021 matched expectations for the entire year. Most forecasts expect HPA to moderate in 2022, falling to 5% to 7% year-over-year. That may happen, but investors should view HPA projections for 2022 as having a tremendous amount of uncertainty. Home price appreciation could become an increasingly important driver of prepayment speeds if interest rates move higher.