After a few days of calm, extreme volatility returned to the mortgage-backed securities market Tuesday morning, as the Federal Reserve allowed the prices of mortgage-backed securities to fall sharply. The spread between US Treasury bonds and mortgage-backed securities jumped as the Fed withdrew from a market that it had supported with massive purchases over the past week.
The chart below shows the spread between Treasuries and mortgages (prices move inversely with yields).
The Fed’s sudden reversal Tuesday morning shows that its no-limit purchases of mortgage-backed securities (MBS) – a $12 trillion market – may backfire badly. Forced sales of MBS by leveraged funds alarmed the Fed, which said that it would buy at least $700 billion in government and mortgage bonds, and may have bought double that amount before the end of this week. That is a warning that the US central bank’s attempt to stabilize fixed income markets is far from finished, and that aftershocks may continue.
The Fed’s action temporarily stabilized the MBS market, although the spread between mortgages and Treasury bonds remains extremely volatile. But the Fed’s fire hose might wreak havoc in two ways.
- By reducing interest rates to zero for overnight money and to less than a percentage point for most safe securities, the Fed gave homeowners the opportunity to pay their mortgages early. That presents a risk to lenders who have no way to hedge it.
- It triggered a wave of margin calls by Wall Street broker dealers to mortgage lenders who had tried to hedge prepayment risk by selling MBS short.
Mortgage bankers are sounding the alarm that the Federal Reserve’s emergency purchases of bonds backed by to home loans are unintentionally putting their industry at risk. In a letter released Sunday, the Mortgage Bankers Association urged the US Securities and Exchange Commission and the nation’s main brokerage regulator to address the problem by telling securities firms not to escalate margin calls to “destabilizing levels.” The Association, whose members provide primary financing to the housing market, asked the regulatory watchdog to issue guidance directing brokers to work “constructively” with lenders. Just last week, four mortgage Real Estate Investment Trusts collapsed due to margin calls.
Tinkering with the US mortgage market, the second-largest fixed income market in the world after US Treasuries, is tricky. Most mortgages are re-packaged as securities and sold to investors. Homeowners’ mortgage payments are bought, sold, stripped, and securitized in the secondary mortgage market. Many are divided into slices, or “tranches,” which assign different parts of the cash flow to different investors (for example, interest-only tranches and principal-only tranches.
Because most mortgages are resold as MBS, the secondary mortgage market is extremely large and very liquid. One important function of this market is hedging. In fact, originators that aggregate mortgages before selling them typically hedge their mortgage pipelines against interest rate shifts. The noted Mortgage Banker Association letter stated, “When lenders issue new loans, they often simultaneously short mortgage-backed securities. This is done because the loans might fall in value before a banker can sell them to Fannie Mae and Freddie Mac. The bet against mortgage bonds helps protect the lender if that happens.”
Depending on its size and sophistication, a mortgage originator might aggregate mortgages for a certain period of time before selling the whole package; it might also sell individual loans as they are originated. There is risk involved for an originator when it holds onto a mortgage after the borrower has locked in an interest rate. If the loan is not simultaneously sold into the secondary market at the time the borrower locks in the interest rate, interest rates could change, and the mortgage originator would be liable for the differences. That’s why originators hedge this risk is to short the MBS in the secondary market.
To summarize the way mortgages are written to homeowners and hedged by mortgage bankers:
- The mortgage lender (Mortgage Originator) commits the loan with a locked interest rate to be applied on the closing date, after which the loan could be sold to the secondary market
- Since the lender would lose money if rates rise before the loan is closed or when he is to sell the loan he originated, lenders short MBS as a hedge.
- At the closing date, the lender closes the deal, and typically sells the loan to a financial intermediary ( mortgage “aggregators”) who purchases newly originated mortgages from smaller originators, and forms pools of mortgages to be sold as securities. That can be done either with government agencies such as the Federal National Mortgage Association, or Wall Street firms. Aggregators also must hedge the mortgages in their pipelines, and they also are exposed to margin calls too if the market moves drastically,
If rates were to rise as a result of MBS prices declining, the lender would be still obligated to offer the mortgage rate that the home buyer locked in. In an unstable market environment, the Fed, in an emergency effort to forestall mortgage market dislocation, has been purchasing hundreds of billions of dollars amount of MBS, causing their price to rise sharply and swiftly. That forced enormous losses on lenders who had sold these securities short as a hedge.
The result is chaos in the mortgage banking industry, and a shutoff in new origination. That in turn will suppress home purchases in an already-weak market
As noted, four mortgage investment firms had trouble meeting margin calls during the past two weeks: MFA Financial, Investco Mortgage Capital, AG Mortgage Investment Trust, and TPG RE Finance Trust. With lenders losing money on hedges, their brokers are demanding that they sell their mortgages or post more cash. Industry sources say that the size of the margin calls is unprecedented, and that the functioning of mortgage financing is in jeopardy.
If the pain were to spread to a “systemically important financial institution,” a costly taxpayer bailout would be required, as in 2008.
That explains why the Fed suddenly reversed course Friday morning and allowed mortgage prices to fall sharply, as an emergency measure to relieve the mortgage bankers.
Dr. Michael Peng is a quantitative analyst at Boston Consulting Group. He has built numerous quantitative risk models for large Wall Street institutions.
Note: An earlier version of this article incorrectly stated that four mortgage investment firms had closed their doors due to margin calls.