Yes, someone holds those Fannie Mae, Freddie Mac and Ginnie Mae mortgage-backed securities. And they don’t usually take kindly to prepayment risks carried by a massive refinance plan.
But these investors can quickly turn outlaw when someone starts talk of messing around with their trillions of invested dollars. There are even suggestions these so-called bond vigilantes are so strong in number and high in value to the economy, that they can meld public policy to their advantage. The mere threat of a massive money pull out of the bond market could quickly dampen short-term lending and slow an already sputtering economy.
And considering the largest investors in agency mortgage-backed securities are the Federal Reserve and Treasury, the investment risks are clearly double-layered and politically charged.
At the center of the issue is speeches given by Edward DeMarco, acting head of the Federal Housing Finance Agency, conservator of the government-sponsored enterprises Fannie Mae and Freddie Mac. In the investment world, inside-the-Beltway types such as Housing and Urban Development Secretary Shaun Donovan can give markets an idea of the future via speeches and subsequent press coverage. One Donavan speech gave a clear indication to the bond markets that change would be coming soon and coming big.
“It was telling that DeMarco focused first on his legal responsibilities as conservator of the GSEs and all their assets — the MBS portfolios, the book of guarantees, the systems, the people,” said Steven Abrahams of Deutsche Bank.
“By emphasizing the conservatorship, DeMarco seemed to signal that his policy calculus was strictly the net impact on the assets and liabilities of the GSEs — not on broader considerations like on housing, the economy or other areas,” Abrahams added.
“The Congressional Budget Office lately has estimated that eliminating income and LTV (loan-to-value) restrictions on refinancing and dropping loan-level price adjustments would generate a $700 million net gain for the GSEs. If true, that might explain why a conservator would consider change.”
But said Abrahams, it is only DeMarco, as conservator of the GSEs, who can authorize change. DeMarco is focused on only a handful of areas where the FHFA could reduce barriers to borrower refinancings.
FEAR OVER REPS/WARRANTS
But what investors care most about, and fear, is that a mass refi plan will do away with outstanding issues regarding representations and warranties. These reps and warrants are the lifeline of investors seeking to recoup some losses. But the issue is really more with how future reps and warrants will be treated in the private market.
Fannie, Freddie and Ginnie pay the bills, therefore the reps and warrants issues matter less to investors. However, in a private market, those investors may shy away if they see that the government can step in to wipe the slate clean. Perhaps a larger point to investors in the seemingly inevitable rise of guarantee fees by the government-sponsored enterprises.
DeMarco said “a logical next step in conservatorship is to continue down the path already started of gradually increasing guarantee fee pricing to better reflect that which would be anticipated in a private, competitive market.”
For investors of today’s mortgage-backed securities, the prospect of steadily increasing guarantee fees have a range of implications, Abrahams notes.
This translates into a higher cost for agency mortgage funds, more drag on refinancing and housing turnover, migration of mortgage lending toward bank portfolio lenders and away from capital markets, and finally a shift in mortgage product mix toward adjustable-rate mortgages and other structures that fit bank asset/liability needs well.
WRITING ON THE WALL
The Securities Industry and Financial Markets Association, a capital markets trade group, recently held a call with members to float the idea that mortgages with loan-to-value ratios higher than 105% should be considered for To Be Announced delivery, that is, into Fannie Mae and Freddie Mac pools.
The fact this idea is even out there is the clearest market sentiment that some sort of refinancing plan is coming.
Of course, as Barclays Capital analyst Nicholas Strand commented, “This could simply be about increasing operational efficiency for originators.”
That is the hedge. But investors don’t believe SIFMA is in the business of helping mortgage originators.
When the Home Affordable Refinance Program was created to help high LTV borrowers refinance, “the program was initially capped at 105 LTV, which was TBA deliverable,” explains Strand. “Only later was the program for 105-125 LTV borrowers created, which was not eligible for TBA and is pooled separately via Freddie’s U6 and Fannie Mae’s CQ programs.”
Meanwhile, real estate investment trusts — huge investors in the TBA market — are required to only invest in quality mortgage, structured finance products. And anything about 105% is not traditionally considered ‘quality.’ However, the external investor can still be circumvented in the case of a mass refi.
“As the Fed is now reinvesting its mortgage principal pay-downs back into MBS, it could direct these purchases toward these high LTV pools to ensure liquidity and execution comparable to TBA,” Strand said. “We could also see the GSEs used in a similar fashion.”
The market interpretation of Strand’s comments can be taken to mean the federal government still maintains a heavy influence in MBS markets. If so, then the Obama administration may be willing to impose massive refinancings on the capital markets in a take-it-or-leave-it mentality.
ATTACKING THE ‘WOE IS ME’ MENTALITY
But would this type of action be enough to contain the ire of the bond vigilantes? Alan Boyce thinks so.
Boyce is chief executive of Absalon Project, a joint venture between affiliates of VP Securities and Soros Fund Management to promote the Danish model of mortgage finance. He has spent more than 25 years in mortgage finance and believes he is extremely qualified to help fix housing. As a Countywide veteran, and paints the former Countrywide, now absorbed into Bank of America, as a 50,000-person staff with only eight people — including Boyce — who actually knew how mortgages are priced.
In a widely circulated white paper, Boyce and co-authors Glenn Hubbard and Chris Mayer, finance and economics professors at Columbia Business School in New York, said the Obama administration would likely buffer any blows to investor confidence by declaring a federal massive refinancing program as a one-time-only affair.
Besides, Boyce said bond vigilantes making the woe-is-me argument for MBS losses associated with refinancing does not hold any logic for the long term.
“If people pay 4% on a mortgage, they are less likely to go delinquent,” he said. “In the end that is better than higher coupons paying more now, but facing an increased chance of default.”
Boyce said the Federal Reserve’s zero interest rate policy has pushed lending costs lower than ever before. Yet, the lack of significant refinancings mean profits on higher coupon MBS are extremely healthy. MBS investors are due a haircut, he feels, if refinancings aid the economy in the long run.
So, investors aren’t looking to get fleeced, either. Boyce takes a moment to crunch numbers in his head, calling out the numerals as he draws a conclusion. “The agency universe is for $24.8 billion to refinance to 4%,” he said.
Including current MBS trading volumes and spreads, Boyce quickly gauges the cost of such a program during a conversation with HousingWire, and says the outlook is far from totally bad for investors.
“If the refinancing program releases reps and warranties, than net profitability, less mortgage servicing rights, means that the banks would break even,” according to Boyce’s quick computations.
Abrahams believes the market is already pricing in a massive refinancing program. He points out the basis is widened as MBS pools continue to prepay out of the Fed, Treasury and GSE portfolios. These MBS were reissued into weak demand as new pools through the TBA market.
“Spreads in MBS near par should continue to widen,” he said. “Pools of 30-year MBS with 5.5% and higher coupons, however, should do well despite discussions of government refinancing. Those coupons have priced in the risk, and the cash flow should continue to provide good performance.”
