MBS market imbalance fueling higher rates

Fannie Mae and Freddie Mac are in the spotlight again over the role some housing-industry experts say they could play in reducing mortgage rates if they resumed a more active investor role in the mortgage-backed securities (MBS) market.

That’s a role those government-sponsored enterprises (GSEs) have not played since prior to entering into conservatorship in the wake of the global financial crisis of 2007-2008. 

The agency overseeing those government-sponsored enterprises (GSEs) — the Federal Housing Finance Agency (FHFA) — is remaining mum on the subject of the GSEs expanding their portfolios of retained MBS via expanded bond purchases, referring to it as speculation only. 

Still, some industry observers say if the goal is to make housing more affordable, then the GSEs could achieve that objective by acting as an active investor in helping to absorb existing excess MBS supply in the secondary market. 

“If the market got the sense that [the GSEs] were back in that role, even on a limited basis compared to where they once were … and they could step in and stabilize things, that would have an impact [on rates] for sure,” said Richard Koss, chief research officer at mortgage-data-analytics firm Recursion. “How likely that is, though, I don’t even know how to handicap.” 

That excess supply, a demand imbalance estimated currently at some $25 billion monthly, has surfaced in the wake of the Federal Reserve launching its tapering program, known as quantitative tightening (QT), an effort to wind down some of its combined multi-trillion dollar portfolio of Treasuries and MBS.

QT was phased in starting in mid-2022 — shortly after the Fed began escalating its benchmark interest rate. As of early January 2024, agency MBS on the Federal Reserve’s balance sheet totaled $2.4 trillion, down from $2.7 trillion in June 2022. 

Historically, prior to the global financial crisis and Fannie and Freddie being placed into conservatorship, the GSEs added “a bit of a cushion” in the market, according to Community Home Lenders of America (CHLA) President Taylor Stork, who also is chief operating officer at Developer’s Mortgage Co.

“They bought mortgage-backed securities when demand fell, causing that demand to come back in line, and then they would slow down when demand was high,” Stork said. “That helped to keep spreads pretty consistent over the years and to make sure that this business [the housing industry] isn’t quite so topsy-turvy every time there is an economic change.”

The Fed’s monetary policy moves over the past two years — tapering its purchase of MBS and Treasuries along with increasing its benchmark interest rate from near 0 to 5.25%-5.5% range — have combined to help drive up mortgage rates nearly 4 percentage points since January 2022 and also expanded the supply of MBS relative to demand. 

Adding to rate pressure and MBS supply last year was the financial woes afflicting banks — another major source of MBS investment.

“You had the bank failures last year, including Silicon Valley Bank, Signature Bank and First Republic,” said Mortgage Bankers Association (MBA) Senior Vice President and Chief Economist Mike Fratantoni. “As a result of particularly Silicon Valley, the FDIC [Federal Deposit Insurance Corp.] wound up with almost $100 billion in MBS, which they were able to sell very quickly at not much of a discount, so that’s done.” 

If there is more MBS supply than demand, then MBS yields are enhanced for investors, resulting in lower bond prices, given the inverse relationship between the two. In a market in which supply exceeds demand, investors have the advantage in pricing.

Higher yields commanded by investors in the MBS market, in turn, push mortgage rates higher in the primary market. That’s because most loan originators rely on securitizations for liquidity and are forced to raise mortgage rates as MBS yields for investors increase — if they want to remain marginally profitable. 

That pricing dynamic also can fuel wider spreads — as measured, for example, by the difference between rates for 30-year fixed mortgages versus 10-year Treasuries.

“We’re basically saying that getting rates down is the most important thing for homeownership affordability, and so it certainly would seem to be in their [the GSE’s] mission [to buy and retain MBS],” Olson said. “That is the reason for our call for action on this and why it’s important.

“… There’s just so many areas where historically excessive rates are causing an imbalance within the system.”

Rate volatility

One component of the rate spread today that is helping to push it well above the historically normal range of 1.7 to 1.8 points, according to Ben Hunsaker, portfolio manager focused on securitized credit for Beach Point Capital Management, is the risk premium demanded by investors to account for the rate volatility sparked in the main by the Fed. 

The spread between mortgage rates and 10-year treasuries rose above 3 points in October of last year and has recently been hovering in the 2.75-point range — in the wake of the Fed’s December meeting in which it signaled it was likely to pivot this year toward rate decreases.

“One of the tricks about mortgages is rate volatility translates directly into prepayment uncertainty,” the MBA’s Fratantoni said. “So, higher [mortgage] prepayment risk directly widens that spread because MBS are sort of uniquely susceptible to that prepayment risk.”

The takeaway: If rate volatility subsides as the Fed makes even clearer in the months ahead where it’s headed on future rate and QT policy, then the risk premium MBS investors require is expected to shrink. That, in turn, should help to contract what has been an abnormally high spread and create some long-overdue persistent downward pressure on mortgage rates.

Hunsaker said a key spread to monitor to better isolate that risk premium is the option-adjusted spread, or OAS. He said the OAS has been hovering in the range of 30 or 40 basis points. A higher OAS implies more return is being demanded by investors for perceived risk.

“I don’t think this [current OAS] range is abnormal,” Hunsaker said. “I think supply and demand is more or less settled out at fair value ranges [in a post-Covid world where the Fed is not the major buyer in the MBS market].

“…As we get through March, April, May, June and we get through the election, you would expect that there’s less uncertainty, or at least a narrower distribution of potential interest rate paths, and if that happens, the option premium [measured by the OAS] that you have to get paid, the incremental yield you have to get paid [for the risk as an investor], should shrink, and so all else equal, that should mean lower borrowing costs….”

Hunsaker added: “How you could get the… option adjusted spread into a different range, then, would require interest rate volatility to come down further [and that’s] independent of supply and demand [factors].”

If the MBS market remains the domain of private-sector investors (i.e., money market funds, overseas buyers, real estate investment trusts, banks and other private players), it is expected to result in a new normal in which rates and spreads settle in a tad higher than in the recent past — when the Fed and/or GSEs also were active investors in MBS.

“Our forecast is for spreads to narrow over the next couple of years, but we’re going to be north of 200 [comparing 10-year Treasuries with 30-year mortgage rates] even once investors adjust, so it’s not going to be the 170 or 180 [basis point spreads] that we always used to think were normal,” Fratantoni said. “That’s just reflecting the new normal [in which neither the Fed nor the GSEs have a finger on the MBS scale as major buyers].”

Fratantoni adds that longer-term, he expects the 10-year Treasury yield to settle at around 3.5%. That implies a new normal for the market where mortgage rates settle in at somewhere around 5.5% longer term, assuming a 200 basis-point spread over 10-year Treasuries.

If the Fed were to end its current round of tapering, however, and reinvest all the proceeds from asset rolloffs into Treasuries, or resume asset purchases, for example, and the GSEs also became more active investors in MBS beyond their existing caps, then spreads and rates could be reduced even further, market experts suggest. 

“In terms of the level of mortgage rates, if Treasuries drop [their yields], mortgage rates will drop, too, as long as that spread doesn’t widen,” Fratantoni said.

He added in a webinar this week sponsored by Snapdocs that an end to the Fed’s QT [asset rolloffs] this year is likely. 

“It should help to bring spreads in,” Fratantoni said, “but it all depends on exactly how they do it.

“I think at least it’s going to bring rates down,” he added.

Recently released minutes from the Fed’s Federal Open Market Committee’s meeting in December indicate that some participants want to start discussing “the technical factors” that would guide a Fed decision to slow the pace of asset runoff “in order to provide appropriate advance notice to the public.” 

In addition, Dallas Federal Reserve Bank President Lorie Logan suggested recently that the Fed should begin to slowly wind down its bond tapering program and ultimately end its QT balance-sheet reduction program. 

By slowing or ending asset runoff, industry observers say the Fed essentially decreases the net supply of bonds in the market — which theoretically should help to narrow spreads and also help to put downward pressure on mortgage rates.

“Given the historically high spreads, this is a good time to move in that direction,” CHLA Executive Director Scott Olson said.

GSE role

If the GSEs stepped back in to purchase MBS only up to their current $225 billion caps under the FHFA’s Preferred Stock Purchase Agreements with the U.S. Treasury Department, however, the impact long-term “would be so modest, so incremental, it’s probably not worth muddying the waters with respect to where we’d like the GSE business models to go going forward,” Fratantoni said. 

The Fed may well slow or even end its existing tapering program this year, but Fratantoni said he doesn’t see the Fed, or the GSEs for that matter, stepping back into the MBS market as buyers/investors in a major way. Under the Fed’s current QT program, it is allowing up to $60 billion in Treasuries and $35 billion in MBS to roll off its balance sheet monthly.

“…I think listening to what Fed officials say, it’s unlikely that they would start buying MBS again, and listening to what FHFA says, it’s unlikely that that would be a policy choice for them, either.

“But if we we’re to gauge what the relative impact would be, there’d probably be a larger impact from the Fed starting [purchases] again than from the GSEs starting again, although it’s not likely either is going to happen.”

Dave Stevens, CEO at Mountain Lake Consulting and former president and CEO of the MBA, stressed, however, even if the GSEs — Fannie and Freddie — used up the remaining combined $266 billion MBS purchase capacity (estimate as of Nov. 30, 2023) under their separate $225 billion retained-mortgage portfolio caps, “it would suck up [the estimated $25 billion monthly MBS imbalance in the market] for at least six months.” Short-term, he added, that would help to drive down mortgage rates and make housing more affordable — during an election year.

“The Federal Housing Finance Agency (FHFA) will not engage in speculation regarding the referenced ideas and theories,” the FHFA media team stated in response to a HousingWire query about the possibility of the GSEs expanding their MBS investments.

Stevens added that FHFA Director Sandra Thompson “is well aware of this issue.” 

“I’ve heard about meetings she’s had with others where she said that [the GSEs returning to the MBS market] has no chance at all being considered, but you know, things change,” added Stevens, who served as a key housing-policy adviser to former President Barack Obama. “She knows that if [President] Joe Biden doesn’t get reelected, her jobs gone. It’s just an interesting time.”

Reporter’s Note: David Stevens, who dedicated his life to the housing industry, serving in both public- and private-sector leadership roles, passed away this week, shortly after HousingWire interviewed him for this story. Stevens, 66, was diagnosed in 2016 with stage 4 prostrate cancer. “The real estate finance community mourns the loss today of one of its great leaders and fiercest advocates,” said MBA President and CEO Bob Broeksmit in a statement issued Wednesday, Jan. 17. You can read more here.