 Mortgage-backed
security.
Do those three words send shivers down your spine? Maybe just the word “mortgage” is
enough to do it? Even during the best of times mortgages are not high on people’s
lists of favored investments. During the recent credit and housing crisis – home
prices were down 10-15% nationwide depending on what index you were looking
at – mortgage-backed securities (MBS) were among the most tainted and
punished investment vehicles. But it is often during times of crisis, and when
negative sentiment is strongest, that opportunities appear. I will argue that
such an opportunity has, specifically Agency MBS.
But before I delve into why I believe there is an opportunity, let us step
back and explore what exactly is an Agency MBS.
History Lesson:
In 1938, as part of Franklin Delano Roosevelt’s New Deal, the Federal
National Mortgage Association (Fannie Mae) was founded as a government agency.
Its aim was to provide liquidity to the mortgage market during a time when
many people were struggling to become home-owners or were at risk of losing
their homes. For the next 30 years, Fannie Mae had a virtual monopoly on the
secondary mortgage market in the US.
Then in 1968 Congress re-chartered Fannie Mae as a shareholder-owned company
and also created the Government National Mortgage Association (Ginnie Mae).
Ginnie Mae is a government-owned corporation within the then-named Department
of Housing and Urban Development (HUD). In 1970, to further expand the secondary
mortgage market (and increase competition), Congress chartered the Federal
Home Loan Mortgage Corporation (Freddie Mac) as another shareholder-owned corporation.
These three entities are examples of a Government Sponsored Enterprise (GSE)
and play an integral role in the US housing market.
What do these companies do?
When you take out a mortgage, the original lender rarely holds the mortgage
for the entire period (say, 30 years) you’ve agree to pay it. Rather
they sell your mortgage to another entity and look to lend out more money.
This selling of mortgages by lenders makes up the secondary mortgage market.
A GSE acts as conduit in the secondary mortgage market; linking mortgage lenders
with investors. They fill this roll by buying “conforming loans” (I
will come back to this term) from lenders and pooling thousands of individual
loans together into a new mortgage-backed security (MBS). A GSE is then able
to sell this newly created security to large institutional investors, including
fund companies.
Investing in mortgages for an individual investor can be difficult. Consider
all of the questions one would ask before purchasing a stranger’s mortgage:
Who are they? What is their income? Where do they live? What is their credit
history?
Now, bundle hundreds of loans into one security and it becomes even more difficult
for an investor. The GSE entities have a simple solution to this problem: they
guarantee the timely payment of interest and principal of their MBS, even if
the underlying mortgages default. If a loan within the pool of loans that make
up the MBS defaults, it is made whole by the GSE and enters their loss mitigation
system. As an investor in the MBS it appears as a pre-payment at par, not a
default. Through this system investors only have to be concerned with the default
risk of one entity, not hundreds of individuals across the nation.
This may seem like a lot of risk for the GSE to be assuming. However, the
GSEs make money by charging a fee for this guarantee – for assuming the
credit risk. Additionally, the GSEs are limited to buying conforming loans.
The Office of Federal Housing Enterprise Oversight (OFHEO) sets the criteria
as to what constitutes a conforming loan. The criterion sets a limit on the
size of the loan (recently increased to $729,750 from $417,000 for a single
family home) but also includes debt-to-income ratios and documentation requirements.
These are intended to be high-quality, prime loans; typically with 20% down
payments and proof of income.
How are the GSEs distinct?
The primary differences between Fannie Mae, Freddie Mac, and Ginnie Mae are
their ownership structures and level of guarantee. As mentioned above, Ginnie
Mae is a government-owned corporation. Ginnie Mae MBS are the only securities
outside of US Treasuries that are carry an explicit guarantee from the US government.
Fannie Mae and Freddie Mac, while charted by Congress, are public companies.
Their MBS are not backed by the full faith and credit of the US Government.
However, many people believe that their bonds are above “AAA” rated
and carry an “implicit” guarantee from the government.
Recent environment:
Why am I taking all of this time to explain exactly what is an Agency MBS?
(Other than to scratch your itch of curiosity for all things bond market
related?) Recently, Agency MBS were trading at historic levels. As the chart
(at right) demonstrates, Agency MBS spreads to Treasuries (the difference
between the two) widened significantly through the first quarter of the year.
Ginnie Mae MBS were trading 2.5 percentage points (250 basis points or bps)
over Treasuries. Its long term average is closer to just 70-100 bps. Fannie
Mae and Freddie Mac saw their spread rise to 290 bps when the normal range
is closer to 125 bps. As seen in the graph, spreads have since narrowed but
remain at elevated levels.
Now you might be saying “Wait, here is that argument for Agency MBS
I was promised earlier. But still, we are talking about a mortgage-backed security!?
I want nothing to do with anything housing related.”
It is precisely that type of sentiment that helped drive these spreads wider.
Add in a global banking and liquidity crisis and you have a recipe for Agency
MBS to trade at historic levels.
 Concerns about the US housing market are warranted. I recently attended a
conference at PIMCO’s headquarters in Newport Beach, California. At that
conference, W. Scott Simon, the head of their MBS department, gave a presentation
on the current environment of the US housing market. It was not an uplifting
presentation. Scott saw vacant homes at all time highs, foreclosures increasing,
and further declines in home prices. Scott and other PIMCO panelists (including
co-CIO Mohamed El-Erian and Paul McCulley) were calling for the government
to intervene further to help stabilize the housing market.
Immediately following Scott’s sober look at housing Jennifer Bridwell,
a member of Scott’s investment team, had a more uplifting topic: “Opportunity
in the Crisis.”
PIMCO believes that Agency MBS are the “most attractive fixed income
opportunity in years.” The firm’s argument follows along these
lines. Despite their domination of headlines, subprime mortgages make up a
relatively small portion of the mortgage market as 80% is comprised of high
quality prime loans. Remember, Agencies are limited to buying high-quality
loans. Agency MBS are very liquid as $300 billion worth trade each day. Additionally,
Agency MBS are collateralized by the homes and not the balance sheets of Fannie
Mae or Freddie Mac. Given the Federal Reserve’s (Fed) creativity in lending
and willingness to bail out the investment bank Bear Stearns, it is difficult
to see the Fed allowing Ginnie, Fannie, or Freddie to default or fail. As such
PIMCO feels that Agency MBS have been a “baby thrown out with the bathwater.”
PIMCO makes two important distinctions that are worth highlighting. First,
they are referring to the Agency MBS and not the Agency debt. Agency debt is
backed by the corporate balance sheets of Fannie and Freddie. Second, by-and-large,
they are avoiding so-called private label MBS, such as those issued by Countrywide
and other mortgage lenders. The private label MBS are not necessarily made
of the same high quality loans and does not carry the same level of guarantee
as Agency debt.
Is Agency MBS starting to sound better? A truly “AAA” rated, liquid
security that has been pushed to historic low levels relative to Treasuries
by a credit crisis and negative sentiment does seem like an opportunity. I
would add two caveats before you run out to load up on this exposure. First,
while we respect the team at PIMCO, they are not the only players with an opinion
out there. In recent conversations with Loomis Sayles (another shop we respect
and have a long relationship with), they have expressed a preference for corporate
credit over Agency MBS. There are always going to be multiple opinions in the
market and we have to weigh and evaluate them constantly. Second, it is important
to evaluate Agency MBS within the context of your unique diversified portfolio.
Do your other fixed-income positions (bonds) already have exposure to this
sector? Is it an appropriate exposure for your risk tolerance and objectives?
Agency MBS is just one area of the market that has been affected by the credit
crisis and housing downturn. It is during these times of market upheaval and
negative sentiment where some of the best opportunities can be found. Knowing
exactly where the opportunities are (and what areas to avoid) can be difficult
and is one reason we maintain balanced diversified portfolios. 
-- Jeff DeMaso
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