Treasuries: Have you ever heard the tragedy of Darth Plagueis the Wise?

I remain a believer in lower interest rates. I remain of the mind that deflation is a much bigger risk than either inflation or the dollar (which is a correlated risk anyway). Still, today's move had a lot to do with month-end rebalancing. The duration of the Barclay's Aggregate has risen from 3.73 on 3/31, to 3.96 on 4/30 and now to 4.33, all on MBS extension. The MBS portion of the Agg has moved in duration from 1.54 on 3/31 to 2.22 on 4/30 to 3.16 now.

So unless rates follow through on Monday, its debatable whether this rally is real. Again, I think the thesis is in tact, but I don't know whether the market believes it or not.

Month-end buying was also highly evident in the corporate market. I came in to do some buying myself and found offerings were like pulling teeth. Since I'm not married to month-end reporting like a lot of people, I decided to roll the dice and see what the market felt like on Monday.

And the stock market? I've seen some month-end window-dressing rallies, but today took the cake.

I suppose I could hot wire this thing...

I expect the Federal Reserve to announce a program to buy long-term U.S. Treasuries. If not at today's meeting, then soon. Interestingly, most commentators I read don't expect the Fed to move in this direction, but to me it seems too easy not to do it.

The Fed's big fear is deflation. We know the Fed has had the printing presses in high gear for several months now, yet still consumer prices barely move. Today we got CPI, a meager 0.2% over the last year. The cash the Fed is producing isn't turning into consumption. As I've said many times, if consumers don't spend more money, at least nominally, there can't be inflation.

Inflation nuts like to complain about the rapid growth of monetary aggregates. M2 for example has risen 9.8% in the last year, or $736 billion dollars. But note that this has almost all translated into excess reserves at banks, which have gone from about $1 billion a year ago, to $622 billion today. In practical terms, money available for consumption is falling.

If the Fed wants to create inflation, it is going to need to overwhelm banks desires for additional excess reserves. That's going to be very tough given that banks are looking at continued increases in loss reserves (despite Citi/BofA's claim that they are profitable). BCA is predicting an additional $1 trillion in losses at banks before the credit crisis is over.

To this end, the TALF is great idea. This program aims to stimulate consumer lending directly, bypassing banks, by reinvigorating the asset-backed securitization market. Already Nissan is doing an auto loan securitization tomorrow, and another major manufacturer is going to follow suit this week. These two deals will combine for $5 billion.

That's all well and good, but it won't address the problem that consumers might not want to borrow. Household liabilities are currently 134% of disposable income, according to the Fed's Flow of Funds report. In addition, households have also seen their net worth decline by $13 trillion. Consumers must continue to save aggressively in order to offset these losses. And despite what some Keynesians say, consumers need to have a decent asset base before a lasting recovery can take hold.

But a lasting recovery can't happen under deflation. Deflation has more destructive power than half the starfleet. Deflation will push home prices even lower, thus exacerbate the problem of negative home equity specifically, and wealth destruction generally.

Currently the Fed is buying Agency debt and Agency mortgage-backed securities (MBS). That program has been a success so far in bringing down spreads on those bonds, especially considering the massive flight away from these securities by foreign buyers.

But that's just the thing: the Fed has brought down the spread on these bonds. The Fed program has helped prevent mortgage rates from rising in recent weeks as Treasury rates rose. But we won't see mortgage rates actually fall until Treasury rates fall. Remember that MBS typically have servicing spread of 50bps, meaning that if investors will buy MBS with a 5% coupon, that translates into a 5.5% actual mortgage rate. So if the Fed wants to see mortgage rates at 4.5%, they have to get investors to buy mortgage bonds at 4%. Investors simply aren't going to buy a mortgage security at a 4% yield if the 10-year Treasury is at 3%.

Forcing Treasury rates lower will be relatively easy. The Bank of England has already set the precedent. On March 5, the Bank of England announced it would be purchasing up to £75 billion in gilts over the next three months. The day after the announcement, even before the first actual purchase, the 10-year Gilt had already fallen by 30bps.

When Treasury yields fall, it puts indirect pressure on all other yields. No other segment of the investing world is so instrumental in pricing so many other investments. The Fed could buy MBS, and bring MBS rates lower, then buy corporates to bring those rates lower, then buy ABS, and munis and CMBS, etc. etc. Or it can just buy Treasury bonds and bring all rates lower at once.

Not only would forcing Treasury yields lower be impactful, it would also easier to achieve. The MBS market is about $8.9 trillion and is made up of thousands of individual securities. By contrast, there is only one 10-year Treasury bond, with about $40 billion outstanding. All the Fed has to do is target the 10-year Treasury and all rates will react substantially from there.

Follow-up on MBS

I got several reader e-mails (accruedint *AT* gmail.com) asking questions about my MBS analysis. Here is a quick and dirty...



That's the basic Bloomberg screen for MBS yield analysis. The "FNCL 6" at the top indicates this is a generic Fannie Mae 30-year 6% mortgage. In the top right you can see the actual pre-payment experience. Where it says "Life 444 18.1" that means that generic Fannie Mae 6's have paid at a rate of 444 PSA or 18.1 CPR. Again, I don't want to go into the minutia how the prepayment models work, but 100 PSA is sort of a base prepayment level assuming no real refinancing incentive. 444 PSA is therefore 444% of the base speed. CPR is closer to a straight prepayment percentage. So this thing has actually paid at a rate of 18 CPR.


On the far left, near the middle you see 103-23. This indicates a dollar price of 103 and 23/32. Or 103.71875% of principal amount. Above this in the yellow boxes is the prepayment speeds which I've entered in. By default it comes up with Bloomberg's model estimates.

In the blue box below the 51 CPR speed is the yield (3.067%) assuming that speed. Then to the right of that is the yield at alternate speeds.


Near the bottom of the page is the average life at each given speed. You can see the average life at 51 CPR is 1.46 years. Note that this is how long it takes for half of principal to be returned. Not all of principal, which is a common misunderstanding.


Investors in MBS should always remember that when you type 15 CPR in for a mortgage, that's assuming a level prepayment rate. But in reality, given that interest rates will rise and fall over time, the actual prepayment experience will be lumpy. Under normal circumstances (which isn't now, for sure), I usually assume that my MBS positions will go through a prepayment spike at some point even if they are currently out of the money.


Post your questions to the comments or e-mail me.

2009 Forecast: Agencies and MBS -- Back door huh?

For the rest of the 2009 Forecast series, click here.

I lump agency debt and MBS together because both are basically wards of the state at this point. They are also the best example of Quantitative Easing working that we have so far.

5-year bullet GSE debt (that is, non-callable) has declined in spread from about +150 in October and November to about +80bps. It will probably get down to about +50 before stalling there. Historically agency debt traded between +20 and +40bps, but I'd say that in a lower liquidity environment, agency paper won't get that tight.

80bps ain't nothin' these days. With the 5-year Treasury now below 1.40%, one could argue that Agencies are generating 57% more income than comparable Treasury bonds. That's going to continue to attract real money buyers looking for something that's both safe and liquid.

MBS suffer from a severe negative convexity problem. MBS investors have essentially sold short an interest rate option to the underlying mortgage borrowers. Those borrowers are now almost universally in the money. Many borrowers will have difficulty actually refinancing (more on that below) but regardless, the price for MBS securities will have difficulty rising above $104 or so with an embedded in-the-money option with a $100 strike.

To see what I mean, notice the price spread across the coupon stack (using Fannie Mae 30-year MBS for February settlement):

• 4.5% Coupon: $101.938
• 5%: $102.750
• 5.5%: $103.203
• 6%: $103.656
• 6.5%: $104.500

This is the current dollar price for a mortgage security with the indicated coupon. Typically the underlying mortgages have a rate 0.5% higher than the coupon rate. Notice, for example, that the 6% bond at $103.656 is less than one point higher than the 5% at $102.75. To me that's telling you that if rates were to fall by 100bps from here (implying the 5-year Treasury is 0.40%), the 5% mortgage would only improve in price by 1 point.

All this is to say that those hoping for price appreciation out of MBS should look elsewhere. But those looking to just collect fat income may have found a home.

Say you buy a generic 6% Fannie Mae MBS at $103.656. According to Bloomberg, that bond will pay at approximately 51 CPR (if you aren't a bond person, just assume that means 51% of the loan will pay down each year, that's close enough). That produces a yield of 3.09% with an average life of 1.5 years.

That isn't half bad considering that Treasury bonds in 1.5 years are yielding about 0.40%. You have some reinvestment risk as the mortgage pays down, but by 1.5 years rates may be rising again, and so maybe that's a good time to be reinvesting anyway.

If you are willing to do a little more work, you can do much better. Say you can find a pool with mostly 2006 borrowers. Most of those borrowers have experienced negative home price appreciation to some degree (not as bad as you might think because we're only talking about conforming loans here, i.e., loans under $417,000). Anyway, couple this with a pool full of borrowers with 90+ LTV? Or mostly coastal geographics? Or relatively low credit scores? You might have a mortgage pool that will repay much slower than average.

Say you can pick a pool that pays at 40 CPR instead of 51 CPR. That increases your yield to 3.82%. 30 CPR? Now its 4.39% wih a 2.8 year average life. That compares very favorably with the 3-year Treasury trading at 1%!

Finding these kinds of pools is somewhat easier in hybrid-ARMs, which I love here on a pure relative value trade. But beware, the liquidity is much weaker in this sector. Otherwise I'd be a bigger overweight in hybrids than I already am. You can also get a lot of good high LTV loans in the GNMA space.

So if you are going to just buy and hold and don't care about keeping up with Treasuries in a rally, MBS are probably as good an investment as any. But I'm underweight MBS, focused entirely on the kinds of specialized pools that I described above. I've basically dumped all my 5.5% and lower bonds.

So to make a prediction about the sector, I'd say the the Fed's continued support will keep dollar prices relatively high, even if Treasury rates back off a bit. But overall I expect MBS spreads will perform extremely poorly should rates fall from here, and that has me cautious on the sector. I'd add heavily to MBS if the 5-year broke 1% or the 10-year broke 1.6%.

Callable agencies are kind of the worst of all worlds. There is no value-adding opportunities through pool selection akin to what can be done with MBS. And you have the same negative convexity problems, where if rates fall you get called away and if rates rise you get crushed. So I'd avoid most callable agency issues.

Mortgage Backed Securities: Its a trap!

The agency-backed mortgage sure is tempting. Fannie Mae 30-year 6% mortgage-backed securities are currently yielding in the 4.40% area with just a 2-year average life, based on Bloomberg figures. That looks pretty good compared with 2-year Treasuries at around 0.66% and 2-year Fannie Mae bullet debt at around 1.50%. Now that Fannie Mae and Freddie Mac are owned by the government, one should view these credits as all the same. Why not take that extra yield?


But beware, there is likely to be a massive difference in MBS performance over the next year, as the government works hard to push mortgage borrowing rates lower. When a borrower repays his/her mortgage in part or in full, that repayment is passed through to the investor at $100. With almost all agency-backed MBS priced at $102 or above, investors will be taking a loss on every loan refinanced. Thus gauging the potential refinancibility of your mortgage-backed security as well as predicting the direction of government policy will be the key. This is especially true of those holding agency CMOs, which remains a popular product among individual and bank investors.


First question is, how low can mortgage rates go? According to Bankrate.com, the national average mortgage rate is now 5.57%, with GSE conforming mortgages probably available in the 5.25% area this week based on forward commitment rates. Rates could easily fall much further. The long-term average spread between the 10-year Treasury and mortgage rates is 152bps, the current spread is 300bps. Given that the Fed has pledged to buy $500 billion in agency MBS in 2009 (equal to half of 2008's total issuance), there is every reason to believe the spread between Treasury and mortgage borrowing rates will fall, at least for GSE conforming borrowers.


Currently about 80% of the fixed-rate agency MBS universe has a rate of 6% or above. Under normal circumstances, we'd expect most of those borrowers to refinance. However, conventional wisdom says the combination of declining borrower equity and strict lending standards are likely to mute refinancings.


Yet despite the national average home price declines, most borrowers within the agency universe probably still have strong equity. The FHFA's Home Price Index (formerly OFHEO) has only declined by 4% year-over-year. In terms of general economics, the Case-Shiller index probably better represents the housing picture. But remember that the FHFA index is calculated by looking at homes with GSE mortgages, so its exactly the relevant index for agency MBS investors.


All this leads to a highly divergent degree of refinancability among agency MBS pools. If you have a pool originated in 2007 with 90% loan-to-value (i.e., 10% equity) those borrowers will struggle to refinance in today's tight credit environment. A pool where the original loan-to-value was 75% and which was originated in 2005 might be highly refinancable should rates continue to fall.


Geographics will also be crucial. Only 21 states have actually experienced price declines according to FHFA, with some very large states suffering outsized declines. A pool with mostly Midwest or Southeastern exposure would not have many underwater mortgages, whereas a pool concentrated in the Southwest would. The former will repay much quicker than the later.

Mortgage prepayment speeds are especially dangerous for investors in collateralized mortgage obligations (CMOs). A CMO structure is dependent on prepayment speeds occurring within some range. But what we are likely to see is some pools pay extremely fast while others pay extremely slow. This kind of bifurcation could easily bust CMO structures and leave investors with cashflows wildly different from what was expected.


The big wild card is government policy. There is talk that Treasury might allow for no-appraisal refinancing, basically lending based on original loan-to-value as opposed to current loan-to-value. Debate the wisdom of this policy as you might, it would case a massive refinancing wave that would make 2003 look like a a splash in the kiddie pool.


Are mortgages worth owning? Sure, but beware of the risks. Investors who need more certain cash flows should look elsewhere. Investors focused on income and who are willing to dig into the specifics of a mortgage pool can find great rewards.

Lower interest rates and home prices

Calculated Risk is one of the best financial blogs going. Accrued Interest should only hope to get 1/10th of their hits. And the blogging world will certainly miss Tanta. She and I had several e-mail conversations over the years and I learned a lot of very useful info about real-life mortgage servicing from her.

However, I really think CR is lawyering in this post from 12/3. In it, CR claims that lower mortgage rates will not improve home prices, only improve home demand. The crux of the argument is...

But the current buyer wouldn't pay much more, because the rational buyer would realize interest rates will probably not be artificially low when they try to sell, and their future buyer would have a higher interest rate and a lower price.

To me, this argument has a few holes. First, an increase in demand, ceteris paribus, will always increase the price of a good. I suppose one could make some kind of non-linear demand curve argument, claiming that demand is higher at the current price point but does not support higher price points. CR doesn't say that, but it sounds like that's what is being advanced.

To follow his logic, however, is to say that buyers are indifferent to interest rates. If rates are high now, they are likely to fall in the future and vice versa. The data doesn't support this at all. Housing prices tend to rise when rates are low and lending standards are easy. That's exactly why we had the boom we just had!

Now maybe CR is saying that the 4.5% would be obviously artificial since its the product of Fed manipulation. Perhaps. But I will say that within the fixed income community, its is widely thought that mortgage rates are fundamentally too high. With the 10-year Treasury at 2.55%, mortgage rates shouldn't be 6%. At least not for conforming (i.e., GSE) loans. Based on more typical ratios, the rate should be 4.5-5%. If they Fed were to manipulate the loan rate back to its long-term norms, why would we expect the rate to rise precipitously in the future? Maybe because Treasury rates would rise if the economy returned to normal, but then we're back to claiming that buyers ignore rates, which they don't.

Put another way, when the Fed pushed short-term rates to 1% in 2003, did buyers abstain from those low-low-low teaser rates loans? Did they rationally assume rates would soon rise in the future? You and I both know the answer.

Another way to think about it is if a home buyer plans on living in the home for an extended period, why not take advantage of the combination of low fixed rate mortgages and low prices currently available? Even if you assume rates may be higher in the future, wouldn't we also assume that over an extended period, say 5-7 years, housing would also recover?

Now remember that new housing construction is well below normal household creation. So ignoring foreclosures, net supply of housing is negative. Thus, even if 4.5% mortgages can't stimulate enough demand to cause home prices to rise, could it create enough demand to soak up foreclosures? If so, that would certainly be a major step in the right direction, no?

The $10 trillion question is whether the Fed can succeed in pushing mortgage rates much lower. The Fed has plenty of money to do it. Remember that although the entire mortgage market is very large, the Fed only needs to manipulate new loans to change the clearing rate. Comparing the Fed's balance sheet to the entire mortgage market is the wrong comparison. Its like saying they can't manipulate Fed Funds by measuring the entire intra-bank lending market.

All they need to do is announce a target and pledge their full resources toward that target. Mortgage rates will drop down to 4.5% very quickly.

Perhaps CR is thinking in terms of 4.5% mortgages "working" in that it "solves" the housing crisis. As I wrote here, there are no magic solutions that will immediately reverse the home price decline or avoid a deep recession. But there are appropriate measures which can help either diminish the downturn or shorten its length. This is one of them.

My God, they aren't kidding!

The Fed will be buying up to $600 billion in debt and MBS backed by Fannie Mae and Freddie Mac. Yeah, that'll move the market. Today we had Agency debt 30-40bps tighter, swaps about 15bps tighter, and MBS about 35bps tighter.

Here is the quick take from that. I love agency and MBS debt for long-term holders, but I'd probably wait for this to settle out before buying anything. This week is classically a poor liquidity week, and we're living in a poor liquidity market. So every event is going to result in outsized moves. You are smarter to buy on the second round, not the first.

Also this should be effective in lowering mortgage rates. Already I'm hearing borrowing rates should be down around 5.5% after today's move. But given where the 10-year Treasury is, mortgage borrowing rates should be able to drop down below 5%. That would help a lot in creating a refi-wave as well as improving housing affordability.

Meanwhile, Goldman priced their FDIC insured deal today at 3-year +220. Immediately traded down to +200. Morgan Stanley, J.P. Morgan, Citigroup, and Bank of America should all be coming with similar deals either this week or next. As I predicted, this came cheap to Agencies by about 20bps.

Will the liquidity be decent in these FDIC deals? I don't see why not. Will it be as good as Agencies? Not at first. Various funds that have "government" mandates may not be able to buy this paper without some sort of approval from council or a board. That may take a few months, but eventually I think actual "full faith" paper (FDIC) will trade tighter than "implicitly" backed (Fannie/Freddie) paper.

It is entirely possible that the Treasury eventually puts a full faith backing on the GSEs, which would negate the above statement. So I'd say at even spread, I like the FDIC paper. If GSE paper is wider, I prefer the GSE.

MBS: Marching into the detention area

While many expected the Treasury to eventually act on the GSEs, few (including myself) expected it to happen over the weekend. So what's the trade in fixed income? There have been four major ideas bandied about Wall Street over the weekend. They are: buy agency debentures, buy agency MBS (mortgage-backed securities), buy credit, and sell Treasuries.

The one I like the most is buy MBS. Yesterday MBS spreads moved dramatically tighter, 55bps in OAS (option-adjusted spread) according to the Lehman index, from +147 to +94. But you haven't missed it yet. For most of the last 10-years, the index OAS has been between 30 and 60bps, so there is plenty of room to tighter further in OAS. I've always felt as though OAS was an over-rated value metric, but today its especially questionable. The Treasury has announced their intentions to buy MBS in the open market, with the clear goal of pushing mortgage borrowing rates lower. Ideally the Treasury would like to set off a refi wave, which would help banks "naturally" delever as well as help separate good loans from bad. In order to get most 2006-2007 borrowers "in the money", mortgage rates probably have to fall to around 5.25%. I think this implies another 50bps of MBS tightening.

Buying agency debentures is less intriguing. Right now non-callable agencies are trading between 50 and 60bps more than comparable Treasury bonds. This spread might fall into the 20's for short-term bonds, but it won't collapse to zero. We don't currently know what the GSEs will look like after 2009, and therefore bonds maturing beyond 2-years shouldn't (and won't) be viewed as truly government-guaranteed.

Credit is highly questionable here. The large-cap financials should benefit significantly from a mortgage refi-wave. This would get the "good" loans off bank's balance sheets, freeing up capital, and clarifying how much each bank truly has in good versus bad loans. But the real catalyst for finance credit will be bank earnings which isn't until next month. Obviously the Lehman situation isn't helping either. Buying new issue bank credits isn't a bad idea as a trade but I'm staying underweight for now.

Non-finance credit makes even less sense. The GSE bailout may have been necessary, but it isn't a panacea for the real economy problems we're facing. I'd stay very high quality within credit.

The direction of Treasury rates is also questionable. There remains significant dollar-related buying, as evidenced by the strong bid for the 10 and 30-year bonds in recent sessions. That is a classic sign of foreign bank buyers, especially given the fact that economically, the yield curve should probably be steeper not flatter. There is also no particular reason to believe the GSE bailout results in dramatically more Treasury supply. Not to mention the simple fact that the economy remains weak which should be a natural support for interest rates. I'm staying close to home on duration.

Agency MBS: You will be tempted by the yieldy side of the Force

Although agency mortgage-backed securities (MBS) have been beaten up the last couple days, avoid the temptation to jump in. Agency MBS spreads are not as attractive as they seem, and the technicals for MBS are horrible.

This has nothing to do with the financial condition of Fannie Mae or Freddie Mac. We'll have to see how the government bailout progresses. Perhaps just the act of allowing the GSEs access to the discount window will be enough to ensure liquidity. But by all indications, protecting the mortgage securitization market (i.e., keeping mortgage borrowing rates low) is a primary goal of any government action. It isn't credit quality which is behind this underweight call. Rather its plain old fashioned market conditions.

MBS analysis is more complex than for other investment-grade bonds, in that the yield on the security is highly depended on the pace of principal repayments. These payments primarily come from two sources: refinancings and housing turnover. Historically, refinancings were the primary driver of changes in mortgage payment speeds. Anytime interest rates would fall, borrowers would rush to refinance and thus pay off their old mortgage. Housing turnover was more consistent, as people tended to move from house to house based on life circumstances as opposed to macroeconomic events.

But times are anything but typical. Various conditions are coming together which will keep homeowners in their current residence far longer than historic norms. There is a large number of homeowners currently underwater on their mortgage, and an even larger number with less than 20% equity. Given that getting a mortgage with less than 20% down payment is difficult and very expensive right now, homeowners who currently have less than 20% equity would have to come up with a lot of cash in order to move to another home.

So the housing turnover element of mortgage principal payments is set to plummet. In addition, the same factors will prevent many refinancings. A borrower underwater on his current mortgage will not be able to refinance his loan just because rates fall 50bps.

This means that the average life of a mortgage is longer than is currently being assumed.

For example, a Fannie Mae 30-year 6% mortgage security currently has a nominal yield of 6.19% and an average life of 5 years. The average life is the median of a Bloomberg survey on prepayment estimates. That calculates to a nominal yield spread of 271bps.

Note that a 6% mortgage security is typically made up of borrowers with a 6.5% mortgage. Currently mortgage borrowing rates are 6.26%, according to Freddie Mac. Under normal conditions, one would assume that a 6.5% borrower is relatively close to a refinancing opportunity. Hence Wall Street prepayment models are assuming that this mortgage will pay principal slightly faster than this time last year.

More likely is that mortgages will prepay at historically slow rates. Cutting Wall Street's estimated prepayments in half, the mortgage's average life goes from 5 years to 9 years. Because the yield curve is so steep, that results in the yield spread falling to 219bps. If you cut Wall Street's estimate by a third, the spread falls to 202bps.

As investors come to terms with the extending average lives, prices are likely to fall rather than yield spreads contract. Holding the 271bps yield spread constant but extending the average life to 9 years causes the price to drop by over 3%.

Technicals for MBS remain ugly as well. Regional banks and credit unions were classically large buyers of agency MBS. But given the capital situation at banks, we are far more likely to see banks as net sellers of MBS over the next year. In addition, Fannie Mae and Freddie Mac will continue to dominate overall mortgage issuance, and both will be under political pressure to expand their guarantee business. This means more supply of agency MBS.

The best plays in MBS are securities where extension risk is limited. That's 15-year mortgages and hybrid-ARM securities. Both have a natural limit to how much interest rate risk can increase, given the shorter maturity/reset.