Head of U.S. Securitized Products John Kerschner and Portfolio Manager Nick Childs discuss the changes the past month have brought to the U.S. mortgage market and explain why they believe the asset class is well positioned to see stronger returns in the months ahead.
- Like many fixed income markets, U.S. mortgage-backed securities (MBS) suffered an extreme loss of liquidity in March, but a swift response from the U.S. Federal Reserve (Fed), including a commitment to buying nearly unlimited mortgages, was successful in stabilizing the market.
- The mortgage market enters the current economic crisis in a significantly stronger position than in the lead-up to the Global Financial Crisis (GFC). Going into 2020, average loan-to-value ratios were near all-time lows, while consumer savings were relatively high and their debt burdens were relatively modest.
- We think mortgages are well positioned to see stronger returns in the months ahead relative to other fixed income markets due to their lower duration, a relatively high yield compared to historical levels, implicit backing of the U.S. government and aggressive purchasing by the Fed.
The Ides of March unleashed unprecedented disruption in global fixed income markets, and U.S. mortgages were no exception. In the worst days of the month, liquidity evaporated in many mortgage-backed securities (MBS). The U.S. Federal Reserve’s (Fed) response – cutting policy rates to zero and committing to nearly unlimited purchasing of mortgages – was swift and, ultimately, successful. The Fed’s commitment to MBS purchases was initially estimated at $200 billion, but this figure was almost doubled in a matter of weeks, demonstrating how seriously the Fed took the need to normalize the mortgage market.
To understand the severity of the liquidity crisis, consider the mortgage-based credit risk transfer (CRT) market. In recent years, U.S. Agencies, particularly Fannie Mae, have gone to great lengths to make these securities eligible for holding in real estate investment trusts (REITs), which not only bought them, but leveraged them. The lack of liquidity and rapidly falling prices in late March strained many REITs. Those that were unable to meet their margin calls (that is, provide more capital to support their leveraged positions) were forced to deleverage rapidly, selling what they could in an illiquid market. CRTs, as securities, were more liquid than the mortgage loan market, making them the easiest and quickest way to raise cash. As such, REITs sold them with less regard to price, pushing prices even lower. A vicious spiral ensued, halted only by the Fed’s announcements.
Why It’s Different This Time
The Fed’s programs to improve liquidity were successful in stabilizing the mortgage market because, unlike the Global Financial Crisis (GFC), last month’s price volatility was the consequence of a sudden and broad economic shutdown. In contrast, the GFC took place after a period of large-scale sub-prime lending with relatively loose underwriting and after large home-price gains begat large-scale home equity withdrawals. Going into that crisis, consumers were significantly more leveraged than they were going into this year. The average loan-to-value ratio (the amount borrowed relative to the value of the house, and thus an indicator of how leveraged the borrower is) is currently near all-time lows, while consumer savings are relatively high and their total debt burdens relatively modest. Also, underwriting has been stricter going into 2020, improving the overall credit quality of the aggregate borrower, while the supply of homes, which was already low in 2019 compared to 2007, will get tighter as new construction slows.
Nevertheless, all recessions have consequences. Home price appreciation is likely to soften and may well fall modestly. However, this again compares favorably to the GFC when home-price appreciation collapsed, falling around 35%. Loss of employment is likely to prompt many borrowers to take advantage of the opportunity for payment forbearance as many of the newly unemployed may take a needed or desired payment holiday. Still, given the previously mentioned underlying fundamentals, we believe most of those borrowers will return to paying when required. Low loan-to-value ratios mean homeowners have more to lose in defaulting. Relatively low debt burdens mean borrowers can both make their payments more easily and/or simply opt to increase their total debt versus selling their homes. Additionally, current or future state and/or federal programs providing payment holidays on other types of debt, such as credit cards or auto loans, could improve homeowners’ overall cash flow.
Continued Support for the Mortgage Market from the Fed
From the perspective of an investor holding mortgages in a portfolio, it is important to remember that Agency MBS securities come with both an interest and principal guarantee, backed by the implicit support of the U.S. government. While there has been some concern in the press about whether mortgage-servicing companies can withstand widespread deferrals of mortgage payments, we think these fears are exaggerated. We believe forbearance will be a significant strain on the servicers, which are generally undercapitalized, as they were not expecting delinquencies to lurch from all-time lows to (potentially) all-time highs in a matter of months. However, given the unprecedented support demonstrated by the Fed for the mortgage market already, we do not expect they would allow a key link in the mortgage business to cause further widespread disruption.
In our view, such support is even more likely considering the volume of mortgages the Fed has already purchased. Between outright buying of mortgages and the quasi-government status of the Agencies themselves, the U.S. government is effectively an owner of a large portion of the mortgage market. Additionally, we see mortgages as a highly efficient way for the government to improve consumer finances. While homeowners are a subset of Americans, lowering interest rates is the traditional way to improve the consumer’s financial health. With interest rates now at essentially zero, nationwide forbearance is an effective – and quick – additional step the authorities can take to bolster the finances of many American families.
Will Mortgage Refinancing Surge?
With interest rates so low, one would expect to see a surge in mortgage refinancing. But we think this is unlikely in the short term. Shelter-in-place orders will deter home buying, and a lack of capacity at mortgage-servicing companies to process loans creates bottlenecks. The mortgage underwriting process is often cumbersome, requiring notarizations and appraisals and even in-home inspections – all of which are more difficult to effect in the current environment.
Additionally, given the extent to which mortgage payment forbearance is sanctioned – a period which could last up to 12 months – technical delinquencies may well rise. However, this will not, as it does in normal times, signal the increased probability of prepayment. On the contrary, these would not be typical delinquencies, as they are not a breach of the contract. However, as technical delinquencies, they would still prohibit homeowners from refinancing their mortgages. As such, the two forces of lower rates and payment holidays, while both intended to support the consumer, tend to compete with each other. The result, in our view, is that increased forbearance will ultimately lower prepayment volatility.
The sum of all these factors is currently reflected in higher, not lower, publicly available mortgage refinancing rates than one would expect in such a low interest rate environment. Because higher interest rates slow both the ability and willingness of borrowers to refinance en masse, we expect refinancings to remain slow in the months ahead.
Outlook for the MBS Market
We think mortgages are well positioned to see stronger returns in the months ahead. The fundamental economic backdrop is more opaque than usual as uncertainty remains high regarding the path and intensity of the COVID-19 coronavirus. However, both the consumer and the nation’s financial institutions generally were stronger going into this crisis than in past crises, and we expect monetary and fiscal policy will remain supportive, adapting as required to support the mortgage market through the current recession.
Meanwhile, U.S. Treasury yields are near historic lows and may have more asymmetric risk than they have had in a while. As the Fed seems reluctant to let yields go negative, the price appreciation available from falling yields is limited, while signs of an economic recovery could cause yields to rise in the short term. Additionally, the current (and likely future) large-scale global stimulus packages could raise a long-term specter of inflation, putting further pressure on yields to rise. Compared to many fixed income markets, mortgages have a relatively low duration, which means the asset class has less of this asymmetric risk.
Finally, mortgage yields have risen. With the Bloomberg Barclays MBS Index currently yielding near 2.3%, the risk/reward tradeoff of these securities, which are backed by the U.S. government and being actively bought by the Fed, looks increasingly attractive as a candidate for structural exposure. More tactically, the Ides of March has created significant dislocations within the mortgage market. Whether it is the result of forced selling by REITs, the Fed buying with the sole intent of supporting the overall market or investors rebalancing their portfolios given volatility in other asset classes, we expect continued opportunities for active management to add value through robust research and careful security selection.
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