The Big Idea

Out-of-consensus calls on agency MBS in 2024

Brian Landy, CFA | November 17, 2023

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.

With most of the MBS universe trading at a discount to par and the possibility that mortgage rates will stay high, the upside to the broad market next year will likely be in pools that can deliver speeds above expectation. High home prices, which should continue to surprise investors by increasing next year, are an avenue to faster speeds. Homes can appreciate at vastly different rates from state-to-state—last year there was a 15% difference in HPA between the highest and lowest state—so investors that concentrate on the states with the most home price growth can boost returns. Supply should edge higher, although that hinges on the pace of new and existing home sales. And as for demand, money managers still seem like the most likely source next year, which should keep spreads volatile as the relative value between mortgages and other asset classes fluctuates.

Home prices have a greater effect on agency MBS prepayments, and value

Changes in mortgage rates have long been the primary risk to the cash flows of agency mortgage-backed securities, but home prices will play an increasingly important role going forward (Exhibit 1). This table shows the change in projected one-year prepayment speeds under two different home price scenarios—home prices increase by 10% and home prices fall by 5%. Those levels correspond to the highest and lowest state-level home price appreciation over the last year—Maine clocked in near 10% and Nevada’s prices fell about 5%.

Exhibit 1. Home prices influence housing turnover.

Change in the projected one-year CPR in each scenario. Fixed rate 30-year conventional loans.
Source: Yield Book, Santander US Capital Markets

The swing in turnover between those rates of home price appreciation represents a roughly 7% differential in prepayment speeds. But the effects of home price appreciation and depreciation are not instantaneous; instead, they build over time. The speed difference at the end of the 12-month window is likely to be about twice as large as this average difference, likely to carry forward into subsequent years and likely to grow if the HPA difference persists.

Home prices can vary widely from one state to another (Exhibit 2). The horizontal axis orders states based on home price appreciation over the last 12 months, from lowest on the left to highest on the right. The vertical axis separates states based on a measure of home price momentum—greater appreciation over the most recent six months than over the previous six months. The thick horizontal and vertical lines represent the values of the state with median home price appreciation and home price momentum.

The top-right quadrant highlights what should be the best states—those with the most appreciation over the last year and that have had accelerating HPA—more appreciation over the most recent six months than the prior six months. Most of these states may not be large enough to pool as their own categories. But in combination these upper right states account for about 25% of monthly production, so there is plenty of collateral available. And most of these states do not command a pay-up, which means this should be a low-cost way to add extension protection.

Exhibit 2. Home price appreciation by state.

Source: CoreLogic, Santander US Capital Markets

Home price appreciation also tends to have the largest effect on higher coupons (Exhibit 3). The table shows the projected prepayment speed change if home prices were to increase by 10% over the next year compared to a baseline of 4% growth, using Yield Book’s prepayment model. Higher coupon cohorts tend to be dominated by new production that came after the massive home price appreciation from mid-2020 through mid-2022. Many of these loans have experienced little net appreciation since origination, so should be more sensitive to future home price gains than lower coupon loans with a lot of home equity. Most of the speed difference comes from housing turnover; there is a small refinance effect in the 6.5%s, but the turnover effect is larger. Refinancing is important for the 7%s, but that coupon is very small.

Exhibit 3. Home prices increase by 10%.

Projected one-year CPR. Fixed rate 30-year conventional loans.
Source: Yield Book, Santander US Capital Markets

Higher coupons are also more sensitive to home price depreciation (Exhibit 4). Choosing higher appreciation states and avoiding lower appreciation (or depreciating) states has a bigger effect than the aggregate difference. For example, the CPR swing between 6% pools with +10% and -5% HPA is slightly over 1 CPR, and that difference should persist longer than a year and be larger in the second year.

Exhibit 4. Home prices fall by 5%.

Projected one-year CPR. Fixed rate 30-year conventional loans.
Source: Yield Book, Santander US Capital Markets

MBS supply should drift higher

Both gross and net supply should come in slightly higher next year (Exhibit 5). Net supply is forecast to increase to $274.3 billion for the year—or roughly $23 billion a month—but is very dependent on home sales. Two popular forecasts, from the Mortgage Bankers Association and Fannie Mae, have different views. The MBA calls for higher sales that suggests net supply should reach $360 billion for the year. Fannie Mae forecasts lower home sales that suggests net supply should fall to roughly $190 billion for the year. The supply forecast in the exhibit represents the average of those two outcomes.

Exhibit 5. Agency MBS supply projection and history.

The data for 2023 includes actuals through October. Projections are used for November 2023 through end of 2024. Projected net supply based on average of model output using Fannie Mae and MBA housing forecasts.
Source: Fannie Mae, Freddie Mac, Ginnie Mae, Santander US Capital Markets

Money managers and foreign investors are likely to be the main buyers of MBS.

The Federal Reserve and banks were net sellers of MBS in the first half of 2023 (Exhibit 6), adding to the supply of MBS that needed to be purchased by other investors. The Fed should continue to permit its MBS portfolio to runoff next year, as the prospect of ending quantitative tightening seem remote. Money managers added the most MBS last year and are still below their pre-pandemic levels of MBS holdings, so should be the largest buyers of MBS next year.

Exhibit 6. Current Agency MBS Investors.

Source: Inside Mortgage Finance, Santander US Capital Markets

There have been calls for to allow Fannie Mae and Freddie Mac to buy MBS again, but that seems improbable. Banks don’t seem inclined to buy MBS, unless the proposal by the Federal Housing Finance Agency to require banks that are members of the Federal Home Loan Bank system to hold at least 10% of their assets in mortgage-related investments is enacted. That could push banks to add MBS to meet that target. Foreign buying and any bank buying should be concentrated in Ginnie Mae MBS, which should generally keep those spreads tighter and more stable than conventional.

Brian Landy, CFA
brian.landy@santander.us
1 (646) 776-7795

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.

Important Disclaimers

Copyright © 2024 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.