October 2, 2012

How long will investors hold onto low yielding MBS?

October 2, 2012

How long will investors hold onto low yielding MBS?

When thinking about rates on home loans, remember two things:

First, QE3 aka QE Unlimited involves the purchase of Fannie and Freddie mortgage bonds, not jumbos or anything else. So rates on loans for the first two conforming loan tiers drop when mortgage bond prices rise on extra demand spurred by the Fed buying (tier 1 is loans to $417,000 and tier 2 is “high balance” loans to a max of $625,500 based on a region’s median price). Rates on jumbos are slightly influenced but not directly impacted by the prices of Fannie/Freddie bonds the Fed is targeting.

Second, a bank or other investor won’t want to own a 30-year security yielding next-to-nothing. Everyone should remember when S&L’s were earning low rates on their investments but having to pay out higher rates to depositors. That is a no-win situation. The answer to that is usually to move into an ARM market. Normally this happens in a high rate environment, but we could see the same thing in this low rate environment.

Regarding point 1, it’s important to note that since high balance loans (tier 2 described above) can only make up a small percentage of any securitized pool, the pricing is meant to limit production. And the Fed is, as best I can tell, not buying specified pools made up of high balance conforming loans. Some investors change their price or rate adjustments, and lenders should expect to see them continuing to widen out. For consumers, this means rates could go up on these high balance loans, which are already about .25% higher than loans to $417k.

But certainly QE3 has helped the overall mortgage rate market to varying degrees.

Since the Fed doesn’t want to take much risk, they usually buy the safest of securities, such as Treasuries or agency mortgages.

QE1 amounted to $1.75 trillion, and started in 2008.

QE2 was rolled out in 2010 due to the high unemployment rate and lack of economic activity (sound familiar?). But after this second round, our 10-yr hit a low yield of 1.38%, so it definitely had the effect of lowering Treasury rates.

Under these programs, for this year alone in fact, the Fed has purchased roughly $360 billion in longer-dated maturities and now controls about 65% of the total gross issuance of all Treasuries available for these maturities. Yes, that’s right – one part of the government issues them, and another part buys them. It is not hard to see why critics say this is ludicrous.

And now we have QE3, with the Fed buying $40 billion of agency loans per month. Depending on whom you ask, this is about all of, or twice, the amount being originated by mortgage companies per month.

But if you’re a pension fund, or a community bank, where a sizeable percentage of your security portfolio is made up of MBS, this sharply reduces investment options. You’re in it for the spread.

If you’re paying .25% on your deposits, and earning 3.25%, that is okay. But if rates slide higher, and suddenly you have to pay 1, or 2, or 3% to your depositors, owning a large amount of MBS paying 3.25% won’t work.

Yes, some of this spread risk can be hedged (protected), but that can be costly.

So will banks become more interested in riskier assets to help generate revenue? Haven’t we seen this before?

Mortgage banks and community bankers are under severe pressure, given the significant cost of additional regulation, extreme competition and the impact of changes on the industry (not to mention a weak lending environment).

Now, according to Pacific Coast Bankers:

Many have begun moving away from government backed securities toward structure, credit or interest rate risk (to generate a return). Unfortunately, there is no free lunch when yields are stuck at such low levels in the market. When this happens, every 10 basis points more you try to capture can be an exponentially impactful move in risk, so extreme caution is warranted.

Ah, unintended consequences…