S Curves

As anyone knows that has pushed a car to its limits, “S” curves can be dangerous.  They are hazardous because you have to go into them more cautiously than a simple curve, even though you can’t see the second curve coming when you need to be taking cautionary measures.

The biggest danger of an “S” curve if you’re driving too fast is the second part of the curve.  Even though you manage to get through the first half with a four wheel drift or some seriously frightening G-forces, chance are that you won’t have enough control to negotiate the second curve in the opposite direction.

The curve you get by graphing prepayment rates against the basis points of difference between the current rate and the rate on an existing mortgage traces out an “S.”

Mtg Rate vs CPR – Approximate Baseline ‘S’ Curve

Much of our effort in the 1980’s was focused on choosing the right kind of “S” and adding in functions driven by employment, house prices, general inflation, etc. to modify that curve.

At one end (the slow end), some prepayments happen every year because people have to pay off their mortgages, even if they are at very low rates compared to the current rate.  Those are families that have deaths or loss of income, job transfers or divorces.  There are even a small number of houses that are destroyed every year, and the old mortgage is paid off by fire or flood insurance.

At the other (fast) end of the prepayment “S” curve, `there are 30 to 40 percent of a pool of borrowers in normal markets who don’t prepay when it appears they have a financial advantage (lower rates).  Like the borrowers whose life circumstances make them prepay a very low rate loan, the borrowers who stay in a higher rate loan have specific reasons they aren’t refinancing.

Some may have lost their jobs, so they don’t qualify (common today).  Others have houses that have lost enough value that a lender won’t create a new loan for the full balance (very common today).  Still others are planning to move in a year or two, so they don’t want to incur the costs associated with originating a new loan.  I’ve even heard about borrowers left in GNMA 15’s after rates had dropped to 8% who told their bank that they believed in completing the original contract they had signed.

The amREIT managers are dealing with the prepayment “S” curve problem right now.

Back when I started this blog, I was expecting the end of the Fed buying in March to present a buying opportunity with wider spreads.  For a variety of technical and macro reasons, exactly the opposite happened.

The PIIG sovereign scare in Europe, for example.  Some amount of the money that flowed toward US Treasuries for safety ended up in Agency MBS with their currently explicit US Government guarantee and slightly higher yield (today just over 50 basis points).

There were also hundreds of billions of “fails” in the system after the Fed stopped buying.  In part, this was because the Fed wasn’t like most buyers, even those “real money” accounts like pension funds and insurance companies.

The insurance and pension private investors are happy to enhance their return by lending out their MBS (for the right interest rate) to sellers that couldn’t deliver on their sale contracts, which keeps the MBS in circulation for the settlement of trades.

The Fed didn’t do that, so the sellers found themselves in a daisy chain of fails because the Fed didn’t just take a 20% swath out of the MBS market, they also took all those bonds out of circulation.

What has happened is a nearly perfect combination of market forces that kept MBS trading at higher and higher prices.  Fear gripped the international markets when a pack of hyenas went after weak European sovereigns using the same “shadow” techniques that served them so well betting with huge hidden leverage against subprime MBS.

Just like it went down with the insolvency of Fannie and Freddie, the profits made by the buyers of CDS protection (credit short sellers) and the eventual cost of the bailout (for Greece, and possibly Spain) were both charged to the taxpayers’ accounts.

Why, you might ask, didn’t the powers that be choose to let the chips fall where they may?

The answer, in shorthand, is that so many “innocent” banks held the paper issued by those failing institutions (or sovereigns, as we saw last quarter) that a failure would have driven literally thousands of banks into insolvency as well.  Think of the Crash of ’29 times ten, or think of the Crash of ’29 if more than half the banks held stocks on margin instead of the relative few who did.

So Euroland ended up with Germany backstopping the ECB to make sure Greece, Spain and Ireland didn’t actually default.  The US ended up with the Fed buying up more MBS than the country created in 2009.

Last week the “current coupon” fixed rate MBS traded to the astounding yield of 3.43%

A Picture of a Market with No Really Good Choices

With short interest rates in the basement, that means a portfolio manager who owns MBS can  (for the moment) collect nearly 300 basis points of yield on every dollar of MBS they finance using three month or shorter repo.

When they use “normal” caution, as a race car driver would entering a curve, those MBS managers hedge the financing risk on the MBS by swapping interest rates.  They agree to swaps that are two, three, or even five years in duration to receive LIBOR in the future in exchange for paying a fixed rate for that 2,3 or 5 years.  That’s why we see mREITs and analysts saying the net financing spread is more like 150 or 200 basis points than the 300 it looks like on the surface.

However, as the Ginsu knife pitchman used to say “But wait!  There’s more!”

The “baseline” assumption is that today’s 4% MBS will have average lives of just five years.  That’s the life assumed when the hedges are executed, and that’s the life assumed when the prepayments are expected to average 313% “PSA” (Public Securities Association).  Put into practical terms, that says nearly 19% of those borrowers will prepay their mortgages every single year (19% CPR, or Constant Prepayment Rate) from 2012 until 2040.

That is about the same as assuming that mortgage rates will stay under 4.5% forever.  Who believes this?  Not any seasoned MBS investor.  If mortgages go back to 6% or higher from 2012 onward, then the borrowers in today’s Fannie Mae pools will only pay off their mortgages when they have to.  Data collected on mortgage prepayment behavior over the past 60 years or so show us that only 5% to 7% of us have to pay off our mortgage loans in a given year. Put in PSA prepayment terms, that’s only 85% to 115% PSA, which translates into 10 to 14 years’ average life.

So what happens when rates go up to more normal levels, and MBS hedged for five years turn into 10 year or longer bonds? In 1989 when mortgage rates hit 10%, 8% MBS traded at just over 80 cents on the dollar, and assumptions about prepayment speeds ranged as low as 80% of the PSA model. It boggles the mind to think how slow the market might think 4% MBS would be.

We do know that a negative funding spread on all the unhedged MBS (all that stuff that might not actually prepay at 19% forever) can put the amREITs out of business, so we have to assume they will sell and take principal losses rather than suffer long-term negative financing spreads.

For the second week in row in her Weekly Crossroads piece, Merrill Ross has included a paragraph in her weekly summary of the mREIT market that lays out the problem of this Hobson’s Choice quite well:

Not For the Faint of Heart. We continue to believe that active portfolio management, normally an anathema to REIT strategies, will be an essential component of earnings optimization during this period of unprecedented volatility in mortgage bonds. We have a strong conviction that there is value in residential cash flows, but that many traditional buy-and-hold strategies could be exposed to erosion of allocated capital, particularly as the Administration experiments with various loan modification programs. Moreover, hedging strategies, generally swapping cash flows against benchmark Treasurys, could suffer from a loss of correlation as the relationship between MBS and Treasurys evolves.

For those who didn’t check the definition, the reason I call this a Hobson’s Choice is that MBS portfolio managers can either choose to buy paper that is way too rich by any historical measure, or they can choose to hold cash and fail to cover expenses.  The bigger they are, the worse the choice.

There are tiny pockets of value (all relative) in the MBS market, and there are technical supply-demand issues that occasionally allow a portfolio manager to buy select bonds at a decent risk-adjusted spread.  But with all the bonds they look at, they had better have one eye on the exit at all times, and/or be ready to throw on hedges that last for ten years rather than 2, 3 or 5.

It’s a great deal like the choice the mortgage originators faced in 2007 — either they would accept lousy mortgages from flaky borrowers or they would die from lack of business.  Stock mutual fund managers faced the same issue in 1999 and early 2000.  They could stop being in the mutual fund business, or they could buy stupidly priced stocks, and hope that by choosing slightly better ones they would survive the inevitable correction.

With MBS trading where they are, and the 10-year Treasury Note hitting a yield of 2.61% today, 15% return on capital probably won’t be sustainable.  The real issue is whether all the amREIT managers will get out of the way fast enough when the correction comes, be it a spread widening, or a general increase in interest rates out in that 5 to 10 year maturity range.



8 Responses to S Curves

  1. Gary Anderson says:

    Howard, Really good work once again shining light on some of the tougher issues confronting the portfolio managers in this sector. I’m going to try to make a couple of points, while recognizing that you are considerably more knowledgeable than I am within this sector.

    Not all companies have the same level of risk due to their varying stragegies of both investment and hedging. The last time I looked at the CMO 10Q, I noted that they finance their leverage more than 80% through 30-90 day financing and just under 20% through longer duration financing. To me that means that when interest rates (read that LIBOR) rise quickly, the NIM for CMO gets hit more quickly than some others like ANH. Conversely, when interest rates (LIBOR) falls, net interest margins expand quickly.

    ANH uses a larger percentage of longer term financing which I infer means they are less vulnerable to interest rate rises. Because I expect interest rates to begin to rise sometime in 2011, I think ANH is currently a better investment than CMO.

    Regardless of strategy, if short term interest rates begin to rise, through actions of the Federal Reserve, the NIM can change quickly as borrowing costs can rise (partially offset by the interest rate swaps) more rapidly than the bond portfolio yield can rise. But this is pretty much dependent upon the duration of financing the company is utilizing.

    Perhaps I’ve grown complacent in thinking I understood the risks. I’d be interested in your thoughts regarding the impact of pre-pay speeds for the two AMREITs that I mentioned.

  2. honkytonker says:

    I thought CMO carried mostly 1 year adjustable mortgage paper. If so, then it seems like the NIM compression resulting from a rise in short rates would fix itself, though not completely and with a year or so of lag time, and provided the increase was not so precipitous as to greatly exceed the YOY caps on the mortgages. Still learning, Howard, so please correct me if I am wrong.

    • hhill51 says:

      Interesting discussion, and very close to the mark (for both gary and honkytonker). What gets lost in the picture is how the reset lag plays out with ARMs. Many have intermediate (rate reset) caps that keep them from raising rates too much at once for the borrowers. Of course that translates into a lag for investors that makes the rise in short-term (financing) rates more painful.
      Thus if LIBOR were to go up from 0.3% to 4% over a six month period, even the holder of currently resettable 1-year ARMs would have to wait on average two years before they could catch up to the financing rate.
      During that period, the value of the ARMs would drift down to the low 90’s, which might cause margin calls, and would certainly hit book value, with leverage. That’s nothing compared to the prices in the 60’s or 70’s you might see on fixed rate 4’s, but it’s worrisome.
      The ANH portfolio tends to be newer hybrids, but hedged as to financing cost until the reset date on the fifth anniversary. They would not have planned on particularly fast prepayments during that period, so I would not expect them to be underhedged (due to slow prepayment) by as wide a margin as Capstead, who tend to own the paper that is already resetting, and which ordinarily prepays faster as a result. Only the rapid rise in rates beyond the intermediate cap as in my example would hurt CMO more than they expect, again precisely because they have planned on their borrowers being (normally) indifferent to mortgage rates as a disincentive.

  3. Pat Donnelly says:

    But if this depression deepens?
    Rates fall and do not stop!
    Japanese rates?
    Whatever capital survives the derivative shake out, seeks out safety, driving the yield down and capital gain up for existing holders.

    • hhill51 says:

      I think the phenomenon of bear market correlation will dominate the flight-to-safety bid. In other words, when capital calls are bouncing around the system like hyperactive pinballs, a significant number of investors will sell what they can get a bid for — those Treasuries.
      Since the next crisis is most likely to be ’caused’ by a failure of confidence for some sovereign or large political subdivision (CA or IL, for example), the confidence in US Treasuries as safe haven will probably only extend out the curve as far as two or maybe three years. The 10-yr Notes and the Bonds will have to price in the inflationary probabilities of a massive recapitalization or bailout for the states or sovereigns.

      • Pat Donnelly says:


        The dearth of capital, destroyed by derivatives will also affect interest rates. But as we all know, they can defy logic for a long time.

        Essentially however, the problem we face is that there has been too much prooductive capacity and too many houses etc. Until demand revives, the banking trick of creating capital from beans, leading reserve creation, will not happen. A great temptation for some to push buttons …..

  4. maxx says:

    great stuff as usual.

    Seems to me with the hint of interest rate increases the market will sell off all amreits in a big way. I wouldn’t want to own any amreits when that starts to happen. Maybe own the short side.

    It appears we are in a bull flattener right now.

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    may as well check things out. I like what I see so now i am following you.
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