Scott Simon, the Twilight Zone MBS Market, and Why He’s Wrong

I spent some time this past weekend reading Scott Simon’s Q&A piece on the mortgage market.  It’s worthwhile to read, because he runs PIMCO’s mortgage and asset-backed securities teams and their portfolios.  But after reading the piece, I have to admit I think he’s wrong a good bit more than he’s right.

On the Fed’s recently completed MBS purchases:

We are unlikely to see a significant market disruption in the Agency market stemming from the Fed’s retreat. First, the retreat had been well advertised for months before the event. Investors knew exactly when the program was going to end and how much the Fed was buying. So it’s not as if anybody woke up and was surprised by the fact that the Fed had stopped buying.

Second, private buyers are in a much better position today than they had been before the Fed started buying. The private balance sheet was seriously impaired by the financial crisis at the time the Fed stepped in with its public balance sheet. But by October 2009 or so, the private balance sheet had improved. The Fed probably could have stopped buying at that point with about $850 billion in completed purchases, but it felt compelled to reach the previously announced total of $1.25 trillion, and so the next $400 billion in MBS drove prices higher.

I don’t think he’s seen this chart:

Banks have been buying MBS alongside the Fed.  The Fed gave them air cover in a sense because as the Fed purchased those MBS, the marks on those assets improved.  Assets that were sitting on bank balance sheets.  So the private buyers he’s referring to are most likely banks who have been bidding in size with the Fed.

However…

That table is from the 4Q’09 Mortgage Metrics report.  So riddle me this, Batman: Why would you overpay for an asset when its fundamentals are deteriorating?  Either you’re stupid, or you’re looking to stop an asset valuation decline; to keep things suspended in mid-air until fundamentals can improve and asset values take off again.

But let’s continue. 

On Yields

As mentioned, the final $400 billion or so of Fed purchases were pricey, and some private investors, including PIMCO, sold a portion of their holdings to the Fed. Thus 2010 began with many money managers underweight mortgages.

So if and when we see mortgages cheapen, we expect to see private institutions stepping in to buy. Even a 15 basis point move could spark a flurry of buying. Therefore, we don’t expect a major widening of mortgage spreads, unless Fannie Mae and Freddie Mac sell some of their holdings, which would be something of a game-changer.

Because we expect investors will continue to buy on the dips, we don’t believe the Fed’s retreat will have a substantial impact on mortgage rates charged to homebuyers. Clearly, broader changes in interest rates will impact mortgage rates, but the end of the Fed’s buying program probably won’t have a significant effect.

Maybe he should look at that report.  Now… From the Q4 ’09 Mortgage Metrics report:

Overall, the percentage of current and performing mortgages fell for the seventh consecutive quarter to 86.4 percent at the end of 2009. The percentages of mortgages 30-59 days delinquent and 60-89 days delinquent were stable during the fourth quarter at 3.4 percent and 1.6 percent, respectively. However, the percentage of mortgages 90 or more days delinquent increased by more than 21 percent from the previous quarter to 4.7 percent, with more loans being held in a delinquent status for longer periods prior to entering the foreclosure process.

 Credit performance is getting worse.  Risks in mortgages should be exhibiting as higher rates because credit risk and liquidity risk premiums will increase.  Funny how that happens, isn’t it?  Where there’s good performance, there’s plenty of liquidity.  Bad perfomance?  No liquidity.  The Mortgage Bankers Association’s latest weekly survey showed a retrace from 5.31% last week to 5.17% this week, but that may be what we’re in for: heightened rate volatility, but directionally heading higher over the short to intermediate term.  The two week change in rates since the Fed ended its program is still an 11bp increase.

Investor Motivation

Money managers and other institutions have been sitting on the sidelines for quite a while, but cash yields are essentially zero, making it very tempting to move out the risk and duration spectrum. This is exactly what the Fed has meant to do with a fed funds rate near zero – make it so that investors can’t stand to be in cash any more. For banks, it makes the spread between cash and Agency mortgages look more attractive, and for investors, it makes risk-adjusted yields on Agencies look competitive.

This sounds like the Fed is brokering in a greater fool theory play.  Banks who bought mortgages alongside the Fed are supposed to be able to sell those holdings (if they want to sell them) to a massive pool of money managers and institutions with money to burn?  At prices higher than what they paid for them while the assets perform worse?  This is bizarro-world stuff.  Down is up, right is left, right is wrong, in is out and out is in.

Success of the Fed’s program

Again, the Fed stepped in when the private balance sheet was completely broken and mortgage spreads – and therefore rates for homeowners – were astronomically high. They fixed it by reversing those damaging trends. I argue the Fed essentially saved the market for medium- and lower-priced houses by halting home price declines. This likely has curbed foreclosures to a degree, although levels have remained elevated. So while not everything the Fed did was perfect, overall we believe the program was a major success.

Huh?  I don’t think the Fed’s actions did anything to stoke demand for housing, or at least nowhere nearly as much as the tax credits being given to first time homebuyers and others.  And seeing how some homeowners are behaving while small business lending pays the price (I’ll explain later), the extension of moral hazard into the Twilight Zone is not a good outcome from all of this. 

Where I Agree with Simon

Agency MBS look expensive vs. 10-year Treasuries but cheaper compared to two-year swaps. We never look at mortgage bonds in isolation, but compare prices against an array of other instruments, so I avoid being too specific about labeling them as cheap or expensive. However, I’ll go so far as to say Agency MBS peaked in richness in late December or early January and finished March still priced on the richer side of fair.

I’d agree, rates are at an extreme low at the front end of the curve, which begs the question of when rates start rising (and thus cheapening those 2 yr swaps), and the liquidity issues I think the MBS market will be in store for will make Treasuries look even cheaper.  So the flattening trade seems to be the one at least some credit folks are legging into.

We continue to believe that lower-priced homes bottomed last year. Higher-priced homes should bottom later this year. If one labels recovery as prices rising dramatically, we do not foresee that anytime soon.

That seems like a given at this point…

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3 Comments

Filed under finance, government, Markets, risk management, Way Forward, You're kidding

3 responses to “Scott Simon, the Twilight Zone MBS Market, and Why He’s Wrong

  1. JM

    Agency MBS purchases is one of two vital pieces. MBS purchases put a soft bid under bank balance sheets for now.

    The other piece is leverage. Last time I checked banks/agencies aren’t offering loans with 2% down (50x leverage) anymore, so there is no way you can sustain rising home prices. Lower leverage means lower prices.

    Even if the Fed keeps the bid under non-performing paper by resuming credit easing, nobody is coming in to pick up the underlying after foreclosure at these prices. Seems only a matter of time before the Fed will resign the game.

    One should actually have more confidence in non-guaranteed MBS because their price actually reflects discounted future cash flow, no?

    • Think that’s true. Kinda like the idea of sticking to the non-guaranteed/non-conforming, because of precisely what you said.

      The problem with buying into non-guaranteed here is the timing around real estate price increases. If I had confidence that we’d see price increases in the next 12-18 months, I’d dip my toe in here and buy at distressed prices. But I’m not in the mood to pay $0.10 now only to dump it at $0.10 later.

      But it’s a good thought.

      • JM

        Sure not an expert on the vol of characteristics of the paper vs. underlying. When real estate prices start to roll over, the discount on non-agency MBS may be really steep.

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