It wasn’t long ago — a few years — when the liquidity of the mortgage-backed security market was in question. In 2014-2016 the supposed “experts” believed that MBS and Treasury instruments would fall out of favor from investors inside and outside of the United States.
They were entirely incorrect. If this had happened (and it did not) mortgage rates would have increased for borrowers and the cost of government debt would have been more expensive. But neither the U.S. Treasury Market nor mortgage-backed security market liquidity has deteriorated or lost favor, and if anything has improved which in turn helps rates for our borrowers. Over the years we’ve seen volatility, certainly, and a wide range of political and economic issues in Greece, China, Russia, Venezuela, Korea, England and so on, but bonds backed by institutions in the United States have come through all of this in great shape. And, of particular interest to lenders, securities backed by mortgages have also sailed along very well.
But how does one define “very well,” or, more to the point, why is liquidity so important? The inability to buy and sell something, whether it is an Orange Edsel or a $1 million Ginnie Mae security, directly determines its price. The U.S. Treasury securities market continues to be the largest and most liquid government securities market in the world. Treasury securities are used to finance the U.S. government, as an investment and hedging instrument, as a risk-free benchmark for pricing other financial instruments, and, not least, by the Federal Reserve in implementing monetary policy. (Yes, Quantitative Easing is still taking place.) Having a liquid market matters for all of these purposes and is thus of keen interest to market participants and policymakers alike.
How do we measure the liquidity? One doesn’t put fixed-income securities on Craig’s Lists. Liquidity typically refers to the cost of quickly converting an asset into cash, or quickly purchasing or selling an asset without causing a drastic change in the asset’s price. And this can be done by looking at the bid/ask spread, which, for agency MBS, is currently less than a tick (1/32nd). But, as every MBS trader and hedging firm knows, some coupons, and securities, are much more liquid than others — and this is reflected in rate sheet pricing for borrowers — but nonetheless the market overall continues to be solid.
At the end of 2018 SIFMA tells us that there are approximately $9.4 trillion of U.S. Mortgage-related securities outstanding . (SIFMA is the Securities Industry and Financial Markets Association.) And starting in June 2019, we will have Universal Mortgage Backed Securities (UMBS), or “UNIs” which are basically pools made up of both Fannie and Freddie loans. Those seeking a more in-depth look can read the FHFA’s Single Security Market Adoption Playbook.
Since the Freddie PCs are being conformed to mirror the Fannie MBS in most respects, there are more changes from the perspective of a Freddie seller than from that of a Fannie seller. It is also important to note that UMBS will still be issued and guaranteed by either Fannie or Freddie, and those UMBS will then be fungible for deliveries into a single TBA market and may be commingled into the same re-securitizations.
Will some lenders or investors be able to tweak (arbitrage, or arb) the system? In the past, companies could take advantage of the price differences between Freddie and Fannie securities. With UMBS, this should go away IF the collateral (i.e. loans) are the same. Also, companies could take advantage of pricing of specified pools that might possess characteristics that the loan investor finds desirable, for example, loans/ pools that the investor expects to have lower prepayment speeds, There may be juggling of TBA (to be announced) securities, or specified pools based on securities that are created using Freddie/Fannie loans that have specific characteristics that investors find more favorable. “Spec Pools” are a source of potential incremental gain on sale — low balance loans are great example…traditionally, loan investors are willing to pay up for loans that result in a lower prepayment speeds. It is important to note MSR/ servicing investors will find that low balance loans are less desirable as they offer less potential servicing cash flows. FHFA has assured the industry that it has done its utmost to minimize any of this occurring.
So what does this mean for residential mortgage bankers? In the past, events and episodes of sharp, seemingly unexplained price changes in certain markets have heightened worry about events in which liquidity suddenly evaporates. There is always a risk of future loss of liquidity. There will always be certain coupons (rates) and products (often ARMs or non-current coupon MBS) that suffer in liquidity. One always runs the risk of a possible imbalance between liquidity supply and demand. However, with all of these worries, let’s end with a positive: at the present moment, liquidity is doing well by historical standards, and liquidity is expected to improve even further with the introduction of UNIs. And that is good for MBS, and thus for borrowers.
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