Thursday, February 11, 2010

Buying out the mortgage market

Mortgage finance twinned with accounting rarely makes compelling reading, but bear with us.

Wednesday’s announcement that the two US Government Sponsored Enterprises (GSEs) will start buying out certain loans, has interesting repercussions for the mortgage market as a whole, as well as the Federal Reserve’s exit programme.

Freddie plans to buy “substantially all” mortgages delinquent by at least 120 days from its fixed-rate and adjustable rate securities. Fannie, meanwhile, will start repurchasing loans for mortgage-backed securities (MBS) trusts that are delinquent by four or more consecutive months.

From Linda Lowell at Housing Wire:

Loan buyouts from Ginnie and GSE pools have been a focus of MBS investor and analyst attention for months now. And it’s a concern that should trickle down to anyone interested in the capacity of the secondary market to foster affordable mortgage rates in the primary market.

Why? Because a buyout is a prepayment. That means the entire remaining principal balance on the loan returns to the investor at par. Unfortunately, most MBS pools are currently priced at a premium to par. Roughly 95% of 30-year fixed rate securities (the heart of the market) are priced over par, at an average price above 104 points (source UBS). That means any investor who carries their MBS positions at market value (and that’s the vast majority) will take an loss on ever dollar that prepays, one that averages to about 4%. Ouch.

Translation: Investors get semi-stuffed in buyouts since they get the whole of their principal back before all their expected interest-payments. If Fannie and Freddie didn’t repurchase the mortgages, they would have to pay missed interest payments to the investors.

Fannie and Freddie have had the ability to buy out loans delinquent by more than 120 days for a while now, but they’ve historically been reluctant to do so. This is where the accounting aspect comes in — until recently both GSEs had to write down bought-out loans to market value, which meant they had to hold additional (expensive) capital against them.

That all changed on January 1 when a new accounting standard — FAS 166/167 — came into effect.

The rule is aimed at bringing things like SIVs and QSPEs back onto balance sheets, but it also has the effect of releasing the GSEs from some of those capital constraints. Under FAS 166/167 the loans are held on balance sheet, so don’t have to be written-down to market value once their bought out.

The new buy-out plans mean higher prepayment speeds at both Fannie and Freddie.The only thing that will constrain them will be the GSEs’ own portfolios. According to some analyst estimates, Freddie has a bit more leeway here than Fannie. But expect some impact on the banks:

Back to Lowell:

Prepayments are the thorn on the rose of government-guaranteed and government-sponsored MBS. Removing credit risk just takes one hurdle out of the investment decision. The problem of anticipating prepayments and adjusting portfolios as needed remains. Only sophisticated institutional investors, with tons of technology in the back office and on their traders’ and PMs’ desks, participate in the MBS market. In the good old days, prepayments could be modeled fairly effectively as a function of interest rates – the impact of mortgage rates on refinancing activity and home sales. Those simple assumptions were swept aside by the housing bubble, weird loan vehicles and bad underwriting. Now, investors have to consider the impact of default on prepayments . . . Uncertainty always carried a cost in the MBS market, so it will be interesting to follow price action and trader color over the next days and weeks.

The market will be even more uncertain given that the Federal Reserve is scheduled to end its $1.25 trillion MBS-purchasing programme in March. Many commentators have expressed worry the private market won’t be able to step in to replace it, resulting in lower or more volatile MBS values.

On that note, we noticed a bit of positive commentary from Laurie Goodman at Amherst Securities:

There will be a lot of cash coming back [because of the Fannie/Freddie buyouts]: approximately $166 billion, $111 billion from Fannie, $55 billion from Freddie, beginning on March 15 and continuing for a few months. This cash will not be matched with additional supply. If this cash is to be reinvested in mortgages, it could have a tightening effect. This will help cushion the effect of the end of the Fed purchase program.

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