Friday, December 2, 2011

What Are The Mortgage-Backed Securities Markets Telling Us?

For several years I managed portfolios of mortgage-backed securities for institutions and mutual funds.

Mutual funds investing in mortgage-backed securities guaranteed by GNMA ("Ginnie Mae") were very popular in the late 1980's and early 1990's. Ginnie Mae carries the full faith and credit of the United States government, so investors are protected from losses from mortgages. Other funds backed by FNMA ("Fannie Mae") and FHLMC ("Freddie Mac") also were very appealing, even though these agencies carried the implied, but not direct, government guarantee.

The appeal of high dividend payouts from government guaranteed mortgages was very attractive to investors dependent on income, especially retirees. For example, I was lead manager on a Ginnie Mae mutual fund targeted to AARP members which grew to a peak of $8.2 billion in five years.

(Of course, Ginnie Mae funds can still lose money if interest rates rise, like they did in 1994. After investors learned this harsh reality, the popularity of Ginnie Mae funds understandably waned).

There are several dynamics to managing mortgage-backed securities, but one of the most important is to try to anticipate prepayment speeds.

As we all know, mortgages can be paid prior to maturity for any number of reasons. When you sell your home, for example, you typically pay off your mortgage. Or if mortgage rates fall, many homeowners will refinance their existing mortgages into new, lower rate mortgages.

One other reason for the early prepayment of mortgages is something that we used to not focus on too much: namely, existing mortgages on a home that is foreclosed will be paid off early when the home is resold at auction.

If you're a manager of a mortgage-backed securities portfolio, then, trying to figure out the approximate rate of prepayment can make the difference between a successful investment and one that produces only mediocre results.

In a period of declining interest rates, the older higher rate mortgages are typically refinanced, but at varying rates of speed. Today, with so many homeowners facing the unpleasant reality that their homes are worth less than their mortgages, refinancing speeds have been considerably slower than economic models would suggest.

While this has resulted in very attractive returns for mortgage-backed investors, it also tells a fairly dismal tale of the state of the housing market in the United States, as Floyd Norris points out in this morning's New York Times:

In normal times, old securities with relatively high interest rates would have virtually disappeared as owners refinanced, paid off the old mortgages and took out loans at lower rates. But these are not normal times, and speculators now are profiting from the woes of homeowners who cannot refinance but have not defaulted. Because Fannie and Freddie guarantee the loans, buyers of those securities are sure to recover the amounts lent.

Prices of high-coupon mortgage securities rose to unprecedented heights earlier this year as investors concluded that those who had not refinanced by then would never be able to do so, and that owners of the securities would be able to collect above-market interest rates for a long time. Those prices have declined, but not by very much, since the administration announced its refinancing plan.

As Mr. Norris points out, many economists in agreement that true economic recovery in the United States will not begin until housing improves.

The unfortunate truth is that until some resolution is reached on how to handle underwater mortgages - and take some of the "juice" away from mortgage-backed investors - our economy recovery seems destined to be muted.