Compelling Value in MBS

By Reber, Jim | Independent Banker, February 2009 | Go to article overview

Compelling Value in MBS


Reber, Jim, Independent Banker


There Are Many Benefits in Imbedded-Option Investments

We're going to try this story from yet another angle.

Last year in this column you read about the huge yields in certain types of amortizing bank investment products. First, last February, I presciently suggested that prepayments were likely to slow down. Then, in July, I pointed out the benefits of leveraging with 15-and 20-year agency mortgage-backed securities (MBS). I followed that up with a story in October about FHA Secure loans backing Ginnie Mae securities. In December, you read about Small Business Administration (SBA) products.

What makes us return to the font of imbedded-option investments again?

Let's begin with the often misunderstood but crucial variable known as spread. Spread in this case means the additional yield an investor will earn over and above a comparable maturity Treasury. Recall that Treasuries are used as a baseline because they are considered risk-free from a default standpoint, and are consequently relatively low-yielding. That is certainly the case as the new year gets moving.

The spreads in traditional MBS expanded to generational-wide levels in 2008 and remained near their "wides" as of the beginning of 2009. This is good news for new investors and not-so-good news for both current holders and potential new homebuyers. It represents an opportunity to buy very high yields relative to Treasuries, and to lock in yields during a near-term horizon that may not see much economic growth.

It also will hamstring current and new homeowners alike by making it difficult economically to either refinance existing loans or borrow new money efficiently.

Strategic Consequences

It may surprise you to learn that over the last three and one-half years mortgage rates have essentially gone sideways. There seems to be a perception among borrowers that home loan rates have roughly tracked Treasury rates lower as the Fed began cutting rates in late summer 2007. There have been some peaks and valleys, but no secular trends have emerged.

What changed, significantly, were the prepayments speeds on virtually all mortgage products. (Chart II, on page 105, shows the slowdown in Constant Prepayment Rates for 30-year agency pools.) It is clear now that a combination of falling home prices (caused in turn by oversupply and falling employment) and a tightening of credit standards have reduced the ability of Joe the Homeowner to sell his house or to refinance.

The tighter credit has manifested itself in MBS yields as well, so while Treasuries are near their all-time low yields, mortgage yields are some 200 basis points wider than recent history. …

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