By the Numbers
Lessons learned in agency MBS in 2022
Brian Landy, CFA | December 16, 2022
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.
The mortgage-backed securities market surprised participants this year with a record drop in securities prices. The average dollar price of an agency MBS was around $102 at the end of 2021 and dropped close to $83 in November, which is uncharted territory for the market. The mortgage basis widened to levels last reached during the 2008 financial crisis. The outlook for home sales, MBS supply, home prices, and prepayment speeds adjusted rapidly in response, which underscores the uncertainty built into those forecasts. Although it seemed likely that regulators would have a larger presence in the market, the FHFA and FHA did not make major policy changes this year. And contrary to expectations heading into the year, Ginnie Mae MBS outperformed conventional MBS.
#1 The mortgage market reprices to record lows and spreads
Market participants expected that the Fed would stop buying MBS, raise interest rates, and possibly allow some MBS portfolio runoff later in the year. But the pace of inflation at the start of the year accelerated plans on all fronts. The Fed stopped buying MBS and started raising rates in March. By June the Fed started allowing MBS runoff and rate hikes had reached 75 bp per meeting.
The MBS market underwent a record adjustment in response. The average MBS price fell nearly $19 over the course of the year, a record drop to a record low. Before this year, the largest annual drop was roughly $7 during the taper tantrum of 2013, and part of that decline was quickly recovered. The average MBS price had never fallen below $95 in the last 20 years. And some investors started to worry that the Fed would begin MBS sales in 2022, although that did not happen.
Mortgage spreads widened, reaching levels last seen during the 2008 financial crisis. The mortgage basis approached 200 bp, wider than the stressed levels at the start of the pandemic. Higher mortgage rates cooled the housing market and lowered net MBS supply. But higher rates also caused banks to start shrinking their mortgage-backed securities portfolios. This kept the supply of MBS that other investors need to buy at historically high levels. Most of these investors are sensitive to spreads and can invest in assets besides mortgages, and that drove spreads wider.
Mortgage-backed securities investors experienced a market that no longer has a large, spread-insensitive buyer of MBS. And that should continue through next year. The GSEs supported the market before the financial crisis and for many years afterwards owned a large, albeit shrinking, share of outstanding MBS. The Fed has been heavily involved since the 2008 crisis, often owning as much as one-third of all MBS. Neither entity is likely to re-enter the market in the foreseeable future. And banks own a historically high share of agency MBS, so seem poised to allow their portfolios to shrink. Lower demand did bring about an expected softening in dollar rolls, which are often trading at or below carry. That should generally continue next year.
#2 Jumbo and conforming mortgage rates invert
Another twist that occurred this year was mortgage rates for jumbo non-conforming loans fell below rates for conforming mortgage loans. Typically, agency-eligible loans are offered at lower mortgage rates since originators can sell the credit risk on those loans. However, this year’s spread widening came from heavy supply and light demand for agency MBS, causing those spreads to widen more than segments of the mortgage market that had little Fed and bank involvement.
#3 Ginnie Mae MBS outperformed conventional
Ginnie Mae MBS unexpectedly outperformed conventional MBS this year. The weaker credit characteristics of FHA and rural housing borrowers raise the risk of a negative credit event if the economy were to weaken or home price appreciation slowed. And Ginnie Mae MBS face greater perceived policy risk in the form of FHA MIP cuts. There are signs that FHA delinquencies are increasing, so these factors may yet play a role in 2023, but they did not hold back Ginnie Mae returns relative to conventional returns in 2022.
Instead, the higher rate environment in 2022 created large mark-to-market losses for banks and sent them looking for zero risk-weighted securities to ease their capital burden. Banks allowed their MBS portfolios to shrink, but any reinvestment was generally done in Ginnie Mae MBS because those have no capital charge. This helped Ginnie Mae outperform conventional.
#4 Significant uncertainty in prepayment and housing forecasts
The events of 2022 highlighted the uncertainty surrounding mortgage market outlooks. For example, at the start of the year many participants argued it was virtually impossible for home prices to fall. But falling home prices became the consensus view by October. Most home price and housing forecasts provide a single forward scenario without much information about the fundamentals and assumptions used to create those forecasts.
Prepayment models are operating in an environment with limited historical data to guide expectations. There is uncertainty as to the correct baseline turnover speed, the strength of the lock-in effect, whether lock-in will fade over time, and so on. The next year should bring more clarity, but in the meantime more uncertainty should be assigned to model predictions.
#5 Government policymakers played a smaller role
Mortgage-related policy changes were unexpectedly modest compared to prior years, despite government-sponsored lending playing a larger role in the market in 2022. More loans were eligible for delivery into agency pools because of higher loan limits. And larger loans typically prepay slower than smaller loans when mortgage rates are high, so jumbo origination dropped relative to non-jumbo origination.
The current administration and policymakers are very focused on affordable housing issues, which raises the risk of disruptive policy initiatives. However, the Federal Housing Finance Agency and Federal Housing Administration were relatively passive last year. The FHFA, Fannie Mae, and Freddie Mac adjusted loan-level price adjustors on a couple of occasions, but the results were targeted at relatively small groups of loans and had little effect on MBS valuations. And the FHA did not lower mortgage insurance premiums in 2022.
The risk of government involvement is probably higher next year, although as always is difficult to predict. The FHFA and GSEs could introduce a streamlined refinance program or bring back a high-LTV refinance option that is compliant with qualified mortgage rules. The FHA hinted in its annual report that it would like to lower insurance premiums next year. And the FHA may need to alter its loss mitigation procedures to be more effective for mortgages with below-market interest rates.
Brian Landy, CFA
1 (646) 776-7795