Net Negative MBS Issuance In 2012?

Every day mortgage companies pump out an average of $1-1.5 billion of mortgages. But every day people pay off their mortgages. Believe it or not, the outstanding balance of agency MBS has increased by only $28 billion over the first 10 months of 2011 versus annualized growth of $440-540 billion over the three-year period of 2007-09. And in 2010, outstanding mortgage-backed securities dropped by $150 billion, mostly due to the $330 billion delinquent loan buyouts by Fannie and Freddie (remember that?). Some analysts believe that the decline in the rate of growth of the agency MBS market over the past two years will continue on in 2012, which makes investors happy but originators grumpy.

In fact, some believe that net issuance (new securities versus loans paying off) of MBS’s will actually be negative next year. The Fed is now reinvesting MBS paydowns, the Treasury’s selling of agency MBS will near completion, and the refi activity is likely to stop increasing further. So if supply drops, and demand continues, we remember from Econ 1A that the price will go up. And if you remember your bond math, when fixed-income prices go up, rates go down.

Besides the Feds, who are purchasing about $1 billion a day of agency mortgage-backed securities, REIT’s (also known as REITs) have had plenty of publicity this year surrounding their appetite for agency residential paper. But their stock prices, often more volatile than the rest of the market, have been in the doldrums for 2-3 months. What’s up with that? Investors are now assigning REIT’s more risk than in the past. This has been due to the risk of prepayments picking up, and REITs don’t perform as well when their portfolios of higher-interest rate loans pay off early and they have to invest the money in lower coupon product. The market is seeing increased prepayments driven by low mortgage rates and from HARP and now HARP 2.0. Other risks are seen from the drying up of repo lines (the main source of borrowed funds is repurchase agreements) and the possible loss of the SEC exemption from the Investment Company Act of 1940. (This would impact the favorable tax status that REIT’s have.)

Experts are quick to point out, however, that some of this can largely be avoided/mitigated with appropriate RMBS selection. Think about it: any REIT buying recently minted residential securities are buying pools filled with loans to credit-worthy borrowers due to tighter underwriting standards, and at current rates. It is easy to make the argument that loans made recently have rates that may be as low as they go, and is it worth the cost and effort for recent borrowers to refinance?

HARP 2.0 has thrown REIT’s a curveball, however, since a REIT with substantial holdings of RMBS backed by pre-2009-vintage mortgages with high coupons and no prepayment “protection” (such as low balances) will see increased prepayments. (A REIT focused on ARMs is a different matter, since agency ARMs with LTV’s above 105% are not eligible under HARP 2.0 to refi into another ARM.)

In a recent research piece Cantor Fitzgerald noted:

the main risks for mortgage REITs as interest rate risk, prepayment risk, liquidity risk, government/regulatory risk, and (for non-Agency mortgage REITs) credit risk. We note that mortgage REITs hedge to some degree against interest rate risk and prepayment risk.” For example, in mortgage rates slide higher, and few expect that until later in 2012, “it is possible that (a) the spread could narrow between yields on mortgage REITs’ RMBS and the cost of mortgage REITs’ repurchase agreements, thereby lowering net interest income, and/or (b) the net change in fair value of mortgage REITs’ assets and liabilities could be negative.

And if rates go the other way, it is possible that mortgage REITs’ RMBS could prepay faster than the speeds reflected in the prices that mortgage REIT’s paid for those securities, thereby (a) accelerating the amortization of the premium paid for those securities, and (b) lowering the yield at which the proceeds of the prepayments could be reinvested. But people smarter than the rest of us believe that mortgage rates are not heading down from these levels.