TBAs – The Daily Tearsheet

Morning Report: TBAs are decoupling from Treasuries

Vital Statistics:

	Last	Change
S&P futures	2919	-96.25
Oil (WTI)	43.46	-2.49
10 year government bond yield		0.73%
30 year fixed rate mortgage		3.3%

Stocks are getting clobbered as the flight-to-safety trade takes hold. Bonds and MBS are up. Note we will have a lot of Fed-speak today, so be aware.

Despite the big move upward in bonds (the 10 – year is up about 2 points), TBAs are barely up. The 2.5 coupon is up about 1/4, and the 3s and up are flat. There is a huge push-pull event happening in the TBA market right now. First, originators who hedge their pipelines with TBAs are getting hit with margin calls, which is causing a bit of a short squeeze in the market. Basically, if an originator can’t make the margin call, the broker will close out their position, and that means buying TBAs to close out the short position. Most lenders have had a call from their friendly TBA broker-dealer already, and you will probably be able to hear the champagne corks popping after we get past Class A settlement next week. People have been white-knuckling it all week.

On the other hand, increasing prepay speeds are making the higher note rates less and less attractive. If you buy a 3.5% Fannie TBA, you’ll pay 104. You will get back 100. You are hoping that you get enough coupon payments to cover that premium you paid. As rates fall, that chance of making back that 4% premium you paid becomes less and less. So, even though the 10 year keeps falling, eventually mortgage backed securities will participate less and less in the rally (or at least the higher note rates will). And it looks like we are about there. This is a big relief for mortgage bankers who have full pipelines and want to ring the register. Now, about that servicing portfolio….

Margin calls harken back to the bad old days of 2008. Are we experiencing something similar? Emphatically, no. In 2008, we had a collapsing residential real estate bubble, and these are the Hurricane Katrinas of banking. Despite all the fears of a recession, delinquencies are at 40 year lows, and the labor economy remains strong.

Speaking of the labor economy, it is jobs day. Jobs report data dump:

Nonfarm payrolls up 273,000 (expectation was 177)
Unemployment rate 3.5% (expectation 3.6%)
Average hourly earnings up 0.3% MOM / 3% YOY
Labor force participation rate 63.4%

Overall, a strong report that should take some wind out of the sails of the bond market. Note that this is February’s report, so much of it will be pre-Coronavirus. US corporations are preparing for a mass experiment in remote working, so some of the effects of virus could be relatively well mitigated.

Remember yesterday, when I showed the Fed Funds futures prediction and said it was a toss-up between how big of a cut it will be? Well, it still is. Except now it is a toss-up between a 50 basis point cut and a 75 basis point cut. ZIRP by June?

Who else is driving the rally in the 10 year? Banks. Banks who hedge their interest rate risk with Treasuries are facing similar issues that mortgage bankers are in the Treasury market. Banks with huge portfolios of mortgage loans will sell the 10 year against it in order to hedge interest rate risk. As rates fall, they will need to buy back some of that hedge. According to JP Morgan, banks need to buy about $1.2 trillion in 10 year bonds to adjust their hedges.

Morning Report: Why mortgage rates don’t exactly mirror Treasury rates

Vital Statistics:

	Last	Change
S&P futures	2788	7
Oil (WTI)	59.1	0.1
10 year government bond yield		2.26%
30 year fixed rate mortgage		4.24%

Stocks are higher this morning on no real news. Bonds and MBS are down small.

First quarter GDP was revised downward from 3.2% to 3.1%. Increased exports offset a downward revision in residential fixed investment (homebuilding). The inflation number was also revised downward and is well below the Fed’s 2% target. The Fed funds futures are now forecasting a more than 80% chance of a rate cut this year.

Initial Jobless Claims ticked up to 215k from 212k the prior week.

In market environments like yesterday, I always seem to get the following question: “Brent, the 10 year is down from 2.4% to 2.25% over the past two weeks. I just ran a scenario and only saw a small improvement in pricing. How come?” The short answer to that question is that mortgage rates are tied to the prices of mortgage backed securities which are influenced, but not determined by the 10 year. (This is why my opening statement always talks about bonds and MBS – they are different animals and will behave differently to changing market conditions)

To make things even more complicated, mortgage backed securities will behave differently depending on the coupon. Take a look below at what a typical MBS screen looks like. This lists the TBAs (stands for to-be-announced) mortgage backed securities that correspond to Fannie Mae loans. If you do a Fannie Mae loan, it is probably going to go into one of these securities. You can see that there is a different security for each month of delivery and note rate. On the far left hand side you can see the coupon groupings. It starts at 3%, then goes to 3.5%, then to 4% and so on. The delivery months are also listed: June, July, and August. Note that the price falls as you go out in the future. This is why a 45 day lock costs more money than a 15 day lock.

During the day, mortgage backed securities will trade and prices will be updated pretty frequently. So, if the 10 year bond rate falls by, say 5 basis points, you could see the implied yield of the Fannie 4% of August drop by 5 basis point, 2 basis points, whatever. It will be a function of the supply and demand for that mortgage backed security. Since these prices are the inputs to the rate sheets you see every day, this is the security that really matters, not the 10 year.

If you take a look at the 4% coupon, you’ll see them trading at just under 103. An investor who buys a mortgage backed security is paying 103 for a bond that will pay 100 at some time in the future. Why would a rational investor do that? The answer lies in the interest. The 4% interest payment is higher than the corresponding rate you would get on the benchmark Treasury, which is 2.375%. That difference is the compensation for paying more than par. The investor is betting that they will get that extra interest for a long enough period to cover the extra 3 points they paid. If the mortgages pay off earlier than expected, then the investor is out of luck. This is why early refinancings are a no-no and why Ginnie Mae is taking action to prevent early refinancings of VA loans.

So, when interest rates fall, like we have seen over the past couple of days, the rates on mortgages don’t fall in lockstep. MBS investors will re-evaluate their prepayment models and figure out the right price to pay given the fact that the period they will get that extra interest has changed. Before, they might have expected to get it for, say 7 years. Now they expect to get it for 6 years. When they crunch the numbers, they come up with a right price to pay for that 4% mortgage backed security. And the price for that mortgage backed security will then be used for everyone’s rate sheets. To make things even more complicated, the change in price for a 3% security will differ from a 4% security. The name for this whole phenomenon is called convexity, and it gets into some gnarly bond math. But the punch line about convexity is that mortgage backed securities have a lot of it, which causes them to behave differently than the 10 year. So, when you see on CNBC that the 10 year bond yield fell 10 basis points, you can’t expect to see a corresponding 10 basis point improvement in mortgage rates. It just doesn’t work that way.

Morning Report: Fed Decision Day

Vital statistics:

	Last	Change
S&P futures	2924.75	3.5
Eurostoxx index	384.06	0.14
Oil (WTI)	71.82	-0.45
10 Year Government Bond Yield		3.08%
30 Year fixed rate mortgage		4.79%

Stocks are up small as we head into the FOMC decision. Bonds and MBS are flat.

The FOMC decision will be announced at 2:00 pm EST today. Be careful locking around that time. Given how much rates have increased ahead of the decision, the bond market is probably set up for a rally if the statement and / or supporting materials contain a dovish surprise. TBAs (and therefore mortgage rates) will be slower to respond to a sharp move in rates however and take a few days to fully react.

One thing to look for: whether the Fed considers its policy stance to be “accomodative.” There has been debate at the Fed whether that term is outdated. FWIW, sub 3% Fed Funds and a continuing bond purchase program sounds pretty accomodative to me, at least compared to Federal Reserve history.

Mortgage applications rose 3% last week. Both purchases and refis rose by the same amount. This is in spite of a big jump in rates, with the 30 year fixed conforming rate pushing 5%. 5/1 ARMS hit 4.22%, the highest since the survey began.

New home sales increased to an annualized pace of 629k in August, according to Census. This is an increase of 3.5% MOM and 12.7% YOY. Inventory sits at 6.1 months’ worth.

Housing demand was unchanged in August, according to Redfin. You can see the effect rising rates and home prices have had on demand. Unfortunately the series doesn’t go back far enough to give much of a historical perspective, but it certainly indicates that the last year has had a marked negative effect on buyers. What will change that? Wage inflation.

Mark Zandi looks at what expanding the housing trust fund might do to alleviate the supply / demand imbalance. He notes that most of the post-bubble building was at the high end price points (urban apartments and McMansions especially), and that entry-level / affordable housing has been neglected. Whether that is a case of NIMBY-ism or higher regulatory costs is open for debate. Zandi estimates that increasing the housing trust fund could add an additional 200k units next year.