Weekly Realist Real Estate Roundup (Part 3 of 7)
Back toÂ Part 2
Mortgage-backed securities are the starting point for all mortgage market pricing and the investment of choice for mortgage REITs
When the Federal Reserve talks about buying mortgage-backed securities, itâ€™s referring to the To-Be-Announced (also know as the TBA) market. The TBA market allows loan originators to take individual loansÂ and turn them into a homogeneous product that can be traded. TBAs settle once a month, and government mortgages (primarily FHA/VA loans) are put into Ginnie Mae securities. TBAs are broken out by coupon rate and settlement date. In the chart below, weâ€™re looking at the Ginnie Mae 4% coupon for October.
Loan originators base loan prices on the TBA market. When they offer you a loan (as a borrower), your rate is par, give or take any points youâ€™re paying. Your originator will then sell your loan into a TBA. If youâ€™re quoted a 4% mortgage rateÂ with no points, the lender will fund your loan and then sell it for the current TBA price. In this case, the TBA closed at 102 21/32, which means your lender will make just about 2.5% before taking into account their cost of making the loan. We are close to making the 4.5% coupon the current coupon.
The Fed is theÂ biggest buyerÂ of TBA paper. Other buyers include sovereign wealth funds, countries that haveÂ trade surplusesÂ with the United States, and pension funds. TBAs are a completely â€œupstairsâ€ market in that they donâ€™t trade on an exchange and most of their trading is done â€œon the wireâ€ or over the phone.
All about Fridayâ€™s jobs report
Market participants eased into the week after the long Labor Day weekend without much data. Bonds sold off ahead of Fridayâ€™s jobs report, and the 10 year bond actually traded above a 3% yield. Bonds rallied again on the weaker-than expected jobs report.
Implications for mortgage REITs
Mortgage REITsâ€”such asÂ Annaly CapitalÂ (NLY), American Capital (AGNC), MFA Financial (MFA), Capstead Mortgage (CMO), andÂ Hatteras FinancialÂ (HTS)â€”announced big drops in book value per share as rising rates hurt the value of their mortgage backed security holdings. The REIT sector has been de-leveraging in order to take risk off the table.
As a general rule, a lack of volatility is good for mortgage REITs because they hedge some of their interest rate risk. Increasing volatility in interest rates increases the cost of hedging. This is because as interest rates rise, the expected maturity of the bond increases, as there will be fewer pre-payments. On the other hand, if interest rates fall, the maturity shortens due to higher pre-payment risks. Mechanically, this means mortgage REITs must adjust their hedges and buy more protection when prices are high and sell more protection when prices are low. This â€œbuy-high, sell lowâ€ effect is called â€œnegative convexity,â€ and it explains why Ginnie Mae MBS yield so much more than Treasuries that have identical credit risk (which is to say none).
Continue toÂ Part 4: Mortgage rates over the week
Browse this series on Market Realist:
- Part 1 - Exploring performance and yields for Mortgage REITs
- Part 2 - Weekly Realist Real Estate Roundup â€“ Fannie Mae TBA trading (Part 2)
- Part 4 - Weekly Realist Real Estate Roundup â€“ Mortgage Rates Jump (Part 4)
- Financials Industry
- Ginnie Mae