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Securitized

Blog published on January 3, 2019

Five Key Themes in the Securitized Market

1. The Fed Unwind and Market Technicals

  • The Fed continues to reduce, or unwind, the size of its balance sheet. The unwind takes a major buyer of mortgage-backed securities (MBS) out of the market, which could present difficult market technicals for the sector in 2019.
  • Some investors are questioning who the marginal buyer of MBS will be in absence of the Fed. Since the Fed began reducing its holdings, money managers have on a percentage basis been the largest net adder of agency MBS.1 Money managers should again be the key to demand, in our view.
  • The Fed unwind could lead to further spread widening, but this could be somewhat offset by low prepayment risks in mortgages. Currently, mortgage prepayment risk is low. However, investors are closely monitoring increasing weighted average coupons (WAC), loan sizes and FICO scores in underlying mortgage loans, as higher-coupon loans are more likely to be refinanced.
  • We note that the Fed unwind doesn’t impact just the MBS market. The Fed sets reserve requirements for banks (typically a percentage of certain deposits on bank balance sheets). Most banks hold their reserves at the Fed. When the Fed shrinks its balance sheet, banks shrink their reserves. This has ripple effects on the ability of the Fed to control short-term interest rates and decreases liquidity across sectors.

2. UMBS on Track

  • Implementation of UMBS appears to be on track and is set to be a major theme in 2019. Fannie Mae and Freddie Mac are working on a joint initiative to issue a single security known as Uniform MBS (UMBS).The Federal Housing Finance Agency in March announced that Fannie and Freddie will start issuing UMBS in June 2019.
  • Having all conventional MBS on a common platform would promote liquidity and deepen the MBS market. Fannie and Freddie combined into one security would also help preserve the to-be-announced (TBA) market,2 which is the most liquid portion of the MBS market. The TBA market is an essential underlying component of the 30-year fixed-rate mortgage that is the backbone to U.S. housing.
  • Investors are wondering how the Bloomberg Barclays MBS indices will evolve and how extensively the Fed will exchange its own Freddie securities. Some investors may be on the sidelines until implementation is fully in place, and there is still a meaningful amount of operational work to be done here (Figure 1).

3. Weakening Housing Fundamentals

  • The housing market is exhibiting signs of weakness, after showing consistent improvement since the financial crisis.3 New home sales dropped 9 percent in October – nearly the steepest decline in sales in three years.
  • Years of strong home price appreciation (HPA) is taking its toll. Rising mortgage rates have exacerbated the affordability constraints for many new buyers.
  • However, inventory levels continue to rise, which has started to depress home prices. The ratio of houses for sale to houses sold increased to 7.4 in October, versus 5.6 at the start of 2018.4
  • A decline in housing fundamentals could lead to lower organic MBS supply in 2019, which could be positive for MBS spreads. That said, the consumer will be challenged by rising rates, still-high student loan debt, slowing confidence among homebuyers and other indications of weakness, which will create challenges at a time when the Fed is stepping out as a major buyer of MBS.

4. LIBOR Reform

  • Libor is currently being phased out as one of the market’s benchmark short-term interest rates. Its replacement will most likely be the Secured Overnight Financing Rate, or SOFR.
  • The ISDA Benchmark Committee announced that if Libor is discontinued and pricing is no longer available, existing securities benchmarked to Libor would use SOFR on a go forward basis.5 ISDA’s announcement gives more indication that SOFR implementation is on track. SOFR-linked bonds total 13 issues at about $30 billion in total value, and the transition to SOFR is expected to continue in 20196 (see A Key Metrics Rundown for Securitized Product Investors).

5. Bigger Role for ABS Fundamentals

  • ABS credit fundamentals largely remain healthy, but we see signs of weakness emerging. In credit cards, the consumer balance sheet is normalizing (largely due to equity outperformance) after improvement in the savings and wealth rate in recent years.
  • In subprime autos, negative headlines still hit newswires, but auto ABS spreads held in. The sector continues to benefit from the debt’s structural support and tightening underwriting criteria. However, new and used auto sales are down slightly and this trend could be reflected in the auto ABS market this year.
  • While 2018 performance was largely based on technical trends, fundamental weakness could play a bigger role in ABS performance this year. Technical trends will not be completely absent, as liquidity could be lower due the Fed’s unwind of its balance sheet. However, the market has largely discounted fundamental trends, such as credit card issuers seeking to diversify away from low-risk convenience users and into revolving balances customers.
  • ABS still benefits from a flight to quality, and saw positive excess returns in 2018. The Corporate, U.S. MBS and Government-Related sectors all saw negative excess returns for 2018.7 

 

 

[1] Morgan Stanley, as of November 30, 2018. Per Fed Flow of Funds data, which looks at how much of the market any one type of buyer holds.

[2] In a TBA trade, the exact securities to be delivered to the buyer are chosen just before delivery, rather than at the time of the original trade.

[3] Mortgage prices are up more than 50 percent since 2012, per the Case-Shiller Index.

[4] Federal Reserve Bank of St. Louis, taken from https://fred.stlouisfed.org/series/MSACSR.

[5] The SOFR compounded setting in arrears rate is the daily SOFR observed over the relevant LIBOR tenor compounded daily during that period.

[6] Wells Fargo, as of December 14, 2018.

[7] Based on the Bloomberg Barclays Aggregate Index, Major Components.

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