Why the Worst Is Over for Mortgage-Backed Securities, Maybe
MBS, which got flattened in March, are on the mend, but some warning signs linger. Like, what if the recession caves the housing market?
Art by Zaiwei Zhang
For the mortgage-backed securities (MBS) market recently, it was like an aerial bombardment, all too reminiscent of the 2008-09 nightmare. Prices skidded and yields rose as investors dumped MBS, remembering the housing collapse that rocked the world a dozen years ago.
With a nasty recession rumbling the heavens, odds are that residential mortgage delinquencies and foreclosures will again increase. While MBS have mostly recovered lately, thanks to the rescue-minded Federal Reserve’s move to buy $650 billion of them, mortgage real estate investment trusts (mREITs) are still way down. According to the FTSE/Nareit Index, they are off 48% this year.
Modeling for the future is tough in the midst of a pandemic, and MBS managers are left with only the 2008 experience to draw from. Trouble is, said Nick Travaglino, who leads Nuveen’s securitized sector team, “We now have a worldwide health crisis, and we’ve never seen anything like it.”
Yes, a recession always features home borrowers who can’t keep up with their payments because they’re unemployed or otherwise strapped. Yet after the 2008-09 debacle, mortgages, the underlying assets of MBS, are in a much stronger position and should muddle through without any big catastrophe. Provided, naturally, that the coronavirus and the economy cooperate.
“We’ve retraced three-quarters of the damage” in the MBS market, said Andy Szabo, senior managing director at Newfleet Asset Management. The key is whether a second wave of the COVID-19 disease appears, he noted. “It all depends on if we can re-open the economy.”
The MBS concept, of course, is to pool mortgages into securities that are bought and sold on public markets. Agency MBS, which are issued by government-affiliated entities, enjoy federal support. Non-agency versions, typically created by investment firms, sport no such government backing, thus they yield more to offset the risk. If an agency MBS goes bad, Washington makes investors whole. If a non-agency obligation does, tough.
By dint of their size, MBS are a pillar of the American financial system. The $10.3 trillion US market for MBS is bigger than that for the nation’s corporate bonds ($9.6 trillion), Securities Industry and Financial Markets Association (SIFMA) figures show. The MBS market is comprised of 16.5% non-agency, with the rest backed by Uncle Sam, via government agencies like Ginnie Mae or quasi-agencies such as Freddie Mac and Fannie Mae.
By current low-rate standards, MBS have fairly decent yields, at an average 1.5% yearly for agency securities, per Bloomberg Barclays Indices, and 2% for AAA non-agency issues. Compare that to risk-free 10-year Treasury notes, at a mere 0.9%. Both kinds of mortgage offerings trail top-rated corporate investment grade bonds (2.4%), not to mention corporate high-yield (6.5%). But hey, corporates don’t have Washington backing them up, as agency MBS do.
A Blessing, Then a Curse
Today’s MBS market has its roots in 1938, during the Great Depression, when President Franklin D. Roosevelt launched the Federal National Mortgage Association, more commonly known as Fannie Mae, to buy home loans from banks. The idea was to remove the risk of holding the loans and encourage banks to issue new mortgages, with the goal of aiding the crumpled housing market.
Later came the idea of packaging mortgages into bond-like securities and selling them in public markets. Fannie sold the first MBS in 1968. They only really took off in the 1980s, when investment bank Salomon Brothers created an enticing alternative product in private label MBS, aka non-agency securities. Private label offerings focused on riskier subprime loans that the government-affiliated organizations shunned. After the turn of the century, though, Fannie and Freddie climbed aboard the subprime express, envious of non-agency profits. Some investors back then got very rich off MBS.
The housing bubble of the aughts was underway, with tragic results. Subprime got out of hand, with lax bank lending requirements allowing hordes of folks who couldn’t afford to carry a home to take out mortgages. With the banks able to palm off their crappy home loans to MBS issuers, they had little incentive to scrutinize borrowers. Since non-agency securities had higher yields than the agency variety, they took off in popularity.
Private label MBS composed 56% of the market in 2007, right before the reckoning. When, inevitably, the entire rickety apparatus collapsed, non-agency securities got vaporized. Freddie and Fannie, which had eased their rules to join the temporarily lucrative subprime party, were in bad shape. The government, which had implicitly supported their MBS, assumed full ownership—and made the support explicit.
In the aftermath, no non-agency MBS were issued until 2010. They gradually crept back, only this time with a lot fewer subprime allocations. Banks, under federal pressure, became much tougher on granting mortgages, demanding better credit ratings than before and substantial money down from home buyers.
Now, many of the loans in a non-agency security are jumbo mortgages. Those are large loans, bigger than Fannie and Freddie will allow (average: $510,000, and $765,000 in very wealthy areas). In other words, well-heeled types hold them, the crowd that doesn’t tend to default on loans.
The Fix Is In
All was going famously until the pandemic and the resulting lockdown gave the US economy a body blow. In March, Wall Street’s most recent dark night of the soul, all financial assets took a beating.
Desperate to raise cash as fears mounted over the fast-spreading coronavirus, investors were unloading everything, even Treasury bonds. MBS investors had the added worry that another housing debacle was coming. Mortgage-backed prices skidded.
Then Congress and the Fed galloped in to save investments in general and MBS in particular. The central bank’s action, buying more than a half-trillion bucks worth of agency mortgage securities, put a floor beneath MBS. Feeling secure, the agencies since have declared a moratorium on foreclosures, at least through June.
Plus, the lawmakers in their rescue package mandated that homeowners could request to postpone paying their loans for up to a year. The program, called forbearance, tacks the delayed payments onto loans, lengthening their term. There are 4.73 million loans in forbearance, representing 8.9% of all active mortgages. Those loans together make up just over $1 trillion in unpaid principal.
Mortgage Securities Dip and Recover Due to Government Help
2020 MBS Prices
$107
5/1
Grim jobless report
3/9
Virus spreads
$105
5/15
Freddie and Fannie
extend foreclosure ban
3/27
Washington
rescue package
$103
3/20 Low point
$101
5/15
6/1
3/1
3/15
4/1
4/15
5/1
$107
5/1
Grim jobless report
3/9
Virus spreads
$105
5/15
Freddie and Fannie
extend foreclosure ban
3/27
Washington
rescue package
$103
3/20 Low point
$101
5/15
6/1
3/1
3/15
4/1
4/15
5/1
$107
$105
$103
$101
5/15
6/1
3/1
3/15
4/1
4/15
5/1
Mar 9.
Virus spreads
Mar 20.
Low point
Mar 27.
Washington rescue package
Mar 1.
Grim jobless report
Mar 15.
Freddie and Fannie extend foreclosure ban
$107
$105
$103
$101
6/1
3/1
4/1
5/1
Mar 9.
Virus spreads
Mar 20.
Low point
Mar 27.
Washington rescue package
Grim jobless report
Mar 1.
Mar 15.
Freddie and Fannie extend foreclosure ban
Source: Thomson Reuters
The forbearance program has drawn criticism for not requiring applicants to document economic hardship. Another problem is that, if you get forbearance, you can’t refinance your mortgage in the future.
REITs Not All Right
Indeed, mortgage REITs are retail products that make up just a fraction, around 5%, of the MBS universe. Institutions, along with the Federal Reserve, are the largest holders of residential MBS, although pension funds have less than 1% of assets in REITs, a CEM Benchmarking study found.
But owing to their heavy concentration among retail investors, it’s instructive that mortgage-holding REITs are still sucking wind. For one thing, this shows that the average investor still is leery about mortgage-backeds. Annaly Capital Management, the largest mREIT, has 75% of its $99 billion in assets from agency MBS. Yet it is down 28% this year. And that’s after a modest comeback from its early-April trough.
Why are mREITs flagging when MBS have come back? As Newfleet’s Szabo explained, a REIT is an equity investment that “reacts to the many whims of the stock market.” As a result, he continued, “the markets’ remembrance of mREITS’ performance during the mortgage crisis in 2008 had investors throwing all mREITS out the window with the baby and the bath water during March and April.”
But Mortgage REITs Are Still Way Down
Percent Change in Total Return for Mortgage Real Estate Investment Trusts in 2020
20
0
February
-8.39%
January
+3.56%
-20
April
+19.41%
-40
May
+2.54%
March
-53.75%
-60
20
0
February -8.39%
January
+3.56%
-20
April
+19.41%
-40
March
-53.75%
May
+2.54%
-60
20
0
-20
-40
-60
+3.56%
January
-8.39%
February
-53.75%
March
+19.41%
April
+2.54%
May
20
0
-20
-40
-60
January
+3.56%
February
-8.39%
March
-53.75%
April
+19.41%
May
+2.54%
Source: Nareit
Another weakness of mortgage REITs is that they load on lots of leverage. This magnifies returns on the way up, but makes losses much, much worse, pointed out Jose Pluto, head of mortgage credit research at Aegon Asset Management. Some trusts have taken on debt that’s 10 times equity, he marveled.
Earlier this spring, the most debt-laden were bled by margin calls. Example: Invesco Mortgage Capital, an mREIT that was leveraged 6.5 times and at year-end 2019, boasted $21 billion in assets. Its enormous amount of debt, much of it short-term ($17.5 billion in repurchase agreements), compelled the REIT to unload much of its MBS trove.
Now the trust has just $1.6 billion in its MBS portfolio. The shares year-to-date are down 59%. In a statement, the REIT said it made sure to “prudently manage the company's portfolio through unprecedented market volatility” from COVID-19’s influence.
Housing: The Deciding Factor
What happens to MBS next hinges on the state of the housing industry upon which they rest. Should home sales go south, so will mortgage origination, along with the MBS market.
Some worrisome signs do exist on housing. The national delinquency rate jumped to 6.5% in April, up from 3.1% in March. That’s three times the previous single-month record set in 2008, reported Black Knight, a real estate data provider. The 3.6 million borrowers who are past due are the most since 2015, a near-recession year.
Still, the situation was worse after the financial crisis. In 2010, the delinquency rate topped 10%. Foreclosures these days, likely as the result of the Washington rescue efforts, are relatively tame. Foreclosure filings totaled 14,148 US properties in April, down 70% from March, by the count of ATTOM Data Solutions.
Meanwhile, the residential real estate market is a mixed bag. Home prices in April rose 7% from a year earlier, although sales were down 18%. The supply of new homes is low, stemming from post-2008 caution.
No one, however, can say the US has a housing bubble waiting to pop. As Millennials (24-39) reach their peak earning years and form families, they surely will want to buy homes. “There is a lot of demand for housing in this country,” said Nuveen’s Travaglino.
Assuming a harsh recession doesn’t intervene with this pleasant prospect, MBS shouldn’t suffer much more than they have already this spring. That’s the hope, anyway.
Related Stories:
CMBS Risk-Retention Deals Gaining More Attention