MBS pricing: constantly evolving.
A changed backdrop for the MBS market has colored the outlook for MBS yield spreads to Treasuries.
When mortgage-to-Treasury yield spreads widened to 170 basis points last August, Kidder, Peabody recommended that fixed-income investors over weight the percentage of their assets allocated to mortgage-backed securities (MBS). Now that those spreads have tightened, many analysts are recommending that mortgage assets in investors' portfolios be significantly cut back.
With a slower housing market and limited collateral, it is our view that spreads will probably narrow further. We expect spreads to narrow from current levels to about 125 basis points. (Mortgage yield spreads are currently trading near the high-end of the 100 to 150 basis point range they have been in since 1986.)
Consequently, even though the relative exposure to mortgage securities in fixed-income portfolios should be lowered from our recommendations of last August, we continue to recommend that investors maintain an above-average exposure to the mortgage securities market.
In this article, we review some of the factors that have been influencing secondary market pricing of agency mortgage-backed securities, and consider what effect these factors are likely to have on mortgage pricing in the near term.
As 1988 drew to a close, mortgage yield spreads widened sharply to levels not visible since the October 19, 1987 stock market decline. Interest rates were rising, the Treasury yield curve was flattening, the collateralized mortgage obligation (CMO) bid for collateral to back CMO offerings was weak, and, anticipating high year-end financing rates, dealers were marking down derivative positions to reduce security inventories.
In March of 1989, mortgage yield spreads widened sharply again, as the market's attention began to focus on pending federal legislation--ultimately enacted as the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA)--to resolve the mounting thrift crisis. The FDIC intervened at Gibraltar Savings & Loan, Los Angeles and New West Savings and Loan, Irvine, California to liquidate billion-dollar portfolios of MBSs, and fear of uncontrolled dumping of securities was pervasive. Moreover, new capital standards and stricter investment accounting guidelines for thrifts provoked additional concern that thrifts would be massive sellers of MBS.
Now, one year later, the market's concerns in 1989 have been validated as many of the problems that confronted the 1989 mortgage market continue to affect today's market. Nevertheless, the mortgage market performed admirably and, by the end of 1989, mortgage securities had turned in the best overall aggregate performance among all major, fixed-income market sectors (Figure 1). In fact, 1989 proved an excellent example of how yield can dominate price performance over relatively short-term investment horizons, particularly in an environment marked by low volatility.
Numerous factors influence the magnitude of MBS-to-Treasury yield spreads. They include prepayment rates and market volatility, the slope of the Treasury yield curve, relative supply and demand and regulatory and structural changes. However, as those who manage secondary marketing activities can attest, the relative importance of these factors vary as mortgage markets and the regulatory environment evolve. Aside from regulatory and structural changes, most of these elements can be directly measured on a continuing basis. Regulatory and structural changes, however, indirectly influence the market's overall supply and demand for securities.
Though confronted by increased new issue volume, the mortgage market turned in a resilient performance in the face of major structural and regulatory challenges in 1989. While still below the peak issuance of 1986 and 1987, the 1989 combined single-class MBS issuance from GNMA, Fannie Mae and Freddie Mac rose $50 billion to $201 billion, an increase of 33 percent from 1988 levels.
Notably, $49 billion, a full 98 percent of the increase, came from the conventional Fannie Mae and Freddie Mac sectors. The strong conventional MBS volume reflected a relatively healthy housing market and accelerated refinancing of adjustable rate mortgages into fixed-rate mortgages and mortgage-for-MBS swaps out of the portfolios of thrifts looking to sell assets to meet tough new minimum capital requirements. In fact, the undersupply of Ginnie Maes resulted in Ginnie Maes being priced relatively high compared to conventional MBS for most of last year.
According to the Office of Thrift Supervision, sales of MBS from thrift portfolios totaled $44 billion in 1989. According to thrift balance sheet data, most of these holdings appear to have been financed with reverse repos, which declined by $43 billion during the same period. Hence, these liquidations brought genuine new supply into a market that was looking for new investors at the margin.
Demand for MBS
While single-class MBS issuance was rising and thrift sales were multiplying, multiclass CMO issuance advanced to yet another record year, moving up from $79 billion in 1988 to $96 billion in 1989. This growth provided broad support to the market throughout 1989 and offered investment opportunities to a growing universe of mortgage investors. More to the point, the unanticipated level of demand in 1989 for both single-class and multiclass mortgage securities provided the necessary counterbalance to the de-leveraging of the thrift industry.
Commercial banks' and investors' move away from investment-grade corporate bonds created new demand for MBS in 1989. Responding to both capital incentives and the search for incremental yield, large, weekly reporting commercial banks--which account for about half the total assets in the commercial banking industry--added $25 billion of MBS, a 54.2 percent increase (not including CMOs), to their portfolios during 1989, following a 1988 increase of $8 billion. These same large banks also increased their real estate loan portfolios by 17.8 percent or $53 billion during 1989, following an 11.9 percent or $32 billion increase in 1988.
During 1989, many investment-grade, corporate bond investors also sought relief from event risk in the corporate market and invested in the MBS market. Although the mortgage market is not without its own form of performance risk (i.e., prepayment risk) bond investors clearly declared their preference for known, measurable prepayment risk instead of the more ambiguous, corporate-event risk. Lower levels of prepayment volatility in 1989, and the on-going development of relatively stable multiclass derivatives--notably CMO planned amortization class (PAC) bonds--further nudged corporate investors to allocate more assets to the mortgage securities market.
Finally, increased participation of foreign investors in the mortgage securities market through privately managed investment funds sponsored by domestic advisors was yet another positive sign for 1989. However, significant, direct foreign investment is still to come.
As a result of the prepayment option, mortgage-backed security pricing is influenced by the same factors that determine the pricing of traded options. Market volatility is one of the more important pricing factors, although the strength of the tie between mortgage spreads and market volatility appears to vary over time and with different measures of volatility. Familiar to most mortgage lenders is the measure of volatility implied by the pricing of put and call options on the Treasury bond futures contract.
Until 1989, implied options volatility and mortgage spreads remained rather steadily linked. However, last year this relationship clearly deteriorated as mortgage spreads widened while implied volatility drifted lower. Moreover, so far in 1990, mortgage spreads have remained uncharacteristically stable while volatility has increased.
Two possible explanations for the recent deterioration of this relationship are the increased use of CMO PAC bonds to provide stable cash flows over a wide range of prepayment scenarios, and valuation problems with the implied volatility measure itself.
In particular, a more appropriate means of measurement would be sensitive to changing levels of volatility at all points on the yield curve, because the prepayment options embedded in mortgage securities are both partially and continuously exercisable during the entire life of the security. For example, although volatility measured by the changing yields on long-term Treasury securities remained relatively low in 1989, volatility on short-term Treasury securities accelerated to the highest levels in two years.
The slope of the yield curve affects mortgage pricing both directly and indirectly. When the spread between long and short rates is large, the economic return to a bank or thrift of financing an investment in MBS is more compelling. When the spread is small, the investment return may not be sufficient. In the future, however, this direct effect may diminish with the growth of the CMO market and the de-leveraging of the thrift industry.
A change in the slope of the yield curve also indirectly influences the pricing of MBS by affecting supply and demand for MBS collateral. A steeper yield curve generally favors higher volumes of new CMO issuance and increased demand for MBS. Moreover, a steeper yield curve also tends to produce more ARM originations and a reduced supply of fixed-rate MBS (Figure 2).
1990 experience and expectations
Early in 1990, Kidder, Peabody predicted mortgage spreads would behave similarly to 1989. Sufficient demand, it was thought, would prevent spreads from widening beyond their widest points of 1989; however, unexpected regulatory and legislative developments, in addition to problems in the real estate markets, would occasionally cause spreads to widen.
We also cautioned that the risk of narrower spreads exceeded the risk of wider spreads. Since the beginning of the year, mortgage spreads have narrowed approximately 10 basis points, and subsequently have traded in a very narrow range just below 140 basis points.
After widening sharply to about 170 basis points last August from about 100 basis points at the end of 1988, mortgage spreads have closely tracked a downward trend line, but so far in the first quarter of 1990, have been unable to tighten beyond the 135 basis-point level of early 1989. In particular, spreads have become increasingly confined between a declining resistance level and a horizontal support level (Figure 3). This pattern, known in technical parlance as a "pennant," suggests that spreads are poised to break out on either the upside or the downside, although the timing of such a breakout is never clear.
The last "pennant" in mortgage spreads developed between early 1987 and the end of 1988. During that two-year period, spreads narrowed to about 100 basis points before turning abruptly to their widest levels last August. At that time, Kidder, Peabody recommended that fixed-income investors increase the percentage of their assets allocated to MBSs. Currently, the firm suggests that the exposure to mortgage securities in fixed-income portfolios be reduced from its recommendations last August, but that investors maintain an above-average exposure to the mortgage market.
The direction of mortgage spreads will be clarified when the trends in at least some of the factors discussed previously, such as market volatility and the slope of the yield curve, are resolved. However, Kidder, Peabody's fixed income research department believes a repeat of the late 1988 and early 1989 experience is unlikely. By contrast, we believe the mortgage market will remain relatively attractive in 1990.
Supply of MBS
Despite the current level of economic uncertainty, the housing sector remains relatively weak. Housing starts increased sharply in January, but weakened in February and March. More importantly, new home sales are sluggish. Not surprisingly, single-class agency MBS originations declined in the first quarter of the year.
In a pattern similar to last year, the rise in interest rates since the end of last year should keep mortgage originations and prepayments at a relatively restrained level. In particular, average fixed-rate mortgage interest rates have risen about 60 basis points since late last year.
Fixed-rate originations will continue to outpace ARMs in 1990. Although the proportion of ARM originations increased to 25 percent in February, the slope of the yield curve will determine if this proportion increases or returns to the 20 percent level.
The extent to which the Resolution Trust Corporation (RTC) decides to use Fannie Mae and Freddie Mac to securitize non-conforming mortgages in the portfolios of failing thrifts still remains uncertain, but such an arrangement could result in a significant increase in conventional MBS originations. Non-conforming mortgages at failed thrifts could total as much as $100 billion.
Although the rate of CMO issuance slowed in March, the volume of new deals soared to record rates in January and February. Kidder, Peabody estimated the average monthly issuance for the first two months of 1990 was $11.4 billion, compared to an average monthly issuance of $9.6 billion during the fourth quarter of 1989.
A decline in demand for commercial and industrial loans, and an overall contraction of credit, have prompted banks to be increased buyers of MBS. Data from large, weekly reporting commercial banks show that in the first two months of 1990, total bank assets rose by $9.9 billion, while MBS holdings (not including CMOs, which are not reported separately) increased $6.5 billion, and real estate loans rose another $10.5 billion. If the current rate of growth in MBS investments is sustained, banks in 1990 will increase their MBS holdings by another $40 billion, compared to a 1989 increase of $25 billion. The collapse of the junk bond market, and declining corporate issuance amidst higher interest rates and a slower economy, have removed competing investment vehicles in favor of mortgages. As a result, banks are clearly continuing to reallocate their assets toward mortgages.
Corporate bond investors will continue to put more money into mortgage market investments in 1990. Although corporate bond issuers have responded to investor concerns by including protective covenants in bond indentures, renewed investor confidence may not quickly return. Moreover, although Kidder, Peabody expects a decline in event risk, the question of fundamental weakness in many corporate sectors remains. In other words, event risk will be replaced by credit risk.
Regulatory and structural changes
Among regulatory initiatives, one is of timely concern that may temporarily slow the growth of banks' MBS holdings. At issue is the introduction of new accounting guidelines that segregate securities held as investments that must be carried at amortized cost from securities held for sale that are carried at market value. These guidelines are intended to distinguish investment securities from securities held for sale, at least in part, on the basis of each financial institution's investment activities. Consequently, some banks and thrifts are reluctant to increase their holdings of mortgage securities until final guidelines are adopted by the Financial Accounting Standards Board (FASB).
Although the regulatory environment does not appear as threatening as last year, the possibility of unsettling developments continues. Consideration is being given, for example, to amending FIRREA to accelerate the pace of thrift resolutions and RTC liquidations. Moreover, based on their interpretation of the powers granted to them by FIRREA, the FDIC and the RTC recently threatened to repudiate interest payments on the collateralized debt obligations of banks and thrifts placed in conservatorship. Although this episode appears to have been put to rest, the threat of similar regulatory action remains.
A sustained rally in the bond market, particularly when accompanied by increased volatility, has traditionally caused spreads to widen. After declining sharply at the end of last year, volatility rose in the first quarter of 1990. However, mortgage yield spreads remained remarkably stable. Also, with the growth in the CMO market during the past two years, along with growing ranks of buyers, any increase in spreads related to volatility will probably be much less than in the past.
Finally, the absence of a consensus forecast for inflation and economic growth has resulted in increased yield curve volatility. The recent slowdown in the rate of CMO issuance in March is evidence of a flatter yield curve. However, despite a relatively flat yield curve throughout 1989, last year's CMO issuance was another record. Moreover, CMO issuance in the first quarter of 1990 continued to follow the record pace set in the fourth quarter of last year.
On balance, the experience of missed opportunities in the mortgage securities market in 1989 will not be forgotten by investors who were searching for incremental yield. The fundamentals for the mortgage market are strong, and will provide the support necessary to absorb ongoing regulatory and structural changes. Consequently, a significant exposure by investors to the mortgage market remains warranted in 1990. [Figures 1 to 3 Omitted]
Michael R. Grupe is a senior vice president with the fixed income research division of Kidder, Peabody & Co., Inc., New York.
|Printer friendly Cite/link Email Feedback|
|Title Annotation:||mortgage-backed securities|
|Author:||Grupe, Michael R.|
|Date:||May 1, 1990|
|Previous Article:||The MBS markets: 1989 and beyond.|
|Next Article:||GSEs: how they rate. Moody's sizes up Fannie Mae's and Freddie Mac's creditworthiness.|