Two major concerns for value hang over the pass-through market right now: the anticipated end to the Fed's MBS purchase plan March 31, 2010 and the likelihood of a sharp jump in involuntary prepayments in GSE pass-throughs (due to modifications and other foreclosure avoidance efforts and foreclosures, which trigger a buyout of the loan from the pool). Those buyouts may be facilitated after January 1 by the Fannie and Freddie's adoption of FAS 167. That's the amendment to securitization accounting rules that will require Fannie and Freddie to report the underlying loans as assets on their balance sheet (and the obligations to investors as liabilities).

[A mixed bag of regulatory challenges and second order effects of adopting FAS 166 and 167 for GSEs, banks and others are the subject of my Kitchen Sink column in the January 2010 HousingWire Magazine. Recommended reading!]

The Monster Technical

The Fed's MBS purchase program was initially announced in November 2008 for up to $500bn over the next several quarters. Operations began January 5, 2009, and in March the Fed expanded the program to as much as $1.25trn with a December 31 deadline. Perhaps in response to increasing concerns among market participants of a "cliff effect" on pass-through pricing and the consequences for primary mortgage rates, the Fed announced it would extend the program at the conclusion of the September FOMC meeting to an anticipated conclusion by the end of the first quarter of 2010. Extending the program would allow it to gradually slow its MBS purchases in order "to promote a smooth transition in markets." At present, it has about $100bn left and has slowed purchases to around $16-17bn per week recently, compared to $25bn earlier this year.

The issue raised by the end of the Fed's purchase program is simple economics 101: since the Fed began buying GSE pass-throughs in January 2009, the Fed has bought the lion's share (a cliche, but fits like a glove in this context) of new pass-through supply (in this rate environment, predominantly 4%, 4.5% and 5% 30-years). When normal amortization and prepayments due to refinancing, home sales and credit events are taken into account, Fed purchases have been a multiple of net new issuance. According to data compiled by analysts at Barclays Capital as of mid-December, net agency MBS issuance was $384 billion (presumably fixed rate, as of December 1 pool reports), while the Fed had bought about $1.1 trillion. That's almost 3 times the net new pass-through supply coming into the market in 2009.

That demand has been sufficient to hold mortgage spreads close to historical tights for months. Moreover, as spreads have tightened, MBS investors have taken advantage of historically tight mortgage spreads to take gains and reduce pass-through exposure. Barclay's analysts put it bluntly: the Fed bought about $1.1 trillion, net supply was less than $400 billion, which means other investors sold the Fed over $700 billion in pass-throughs. That leaves MBS investors significantly underweight according to MBS analysts at J.P. Morgan. They periodically conduct investor surveys, and their December survey, covering over $1.4 trillion in mortgage assets and over 130 investors, indicated over half were "underweight" (e.g. versus an index or investment guidelines) and only 27% were "overweight."

Barclays analysts used Fed Flows of Funds and other data (through Q209) to identify the sectors that sold MBS (actually, this data doesn't indicate selling, it only indicates changes in aggregate holdings, which would include runoff from amortization and prepayments, but it does point in the right direction). What they found was that money managers, mutual funds and insurance companies – all unleveraged investors – together sold over $300bn in the first six months (annualized that would be more than $600bn).

This leaves several questions hanging over the market: how much will spreads widen in response to Fed departure, at what levels will underweight investors reload, and at what levels do pass-throughs settle into long term, no Fed support equilibrium? Bear in mind the GSE's are due to start reducing their portfolios by 10% per annum starting in 2010, so they can no longer perform their historic role of providing a floor for pass-through values.

Analysts continue to answer with great circumspection. Spreads could widen 30 to 40 basis points initially on the Fed's departure before the underweight investors and banks increase their demand. Longer term questions remain unanswered in print.

Analysts at J.P. Morgan also warn that a couple of "catalysts" could precipitate a widening in mortgage spreads while the Fed is still supporting the market. The first would be a sharp sell-off, pushing 10-year yields to levels (say above 4%) that could trigger extension and additional delta hedging (hedged investors must sell more Treasuries, pass-throughs, etc. as mortgage durations grow with rising yields and falling prepayment expectations). Such a scenario played out last May when current coupon yields rose over 100 basis points and mortgage widened by more than a point, all while the Fed was buying at a $25bn-a-week clip.

The second catalyst could be GSEs selling to fund and making room for buyouts of delinquent loans. And that's my segue into the second huge value concern haunting pass-through investors – how big a jump in prepayments should investors expect? Particularly in securities with prices above par – what MBS investors know and few outside the market appreciate, prepayments come back at par, for an instant loss on that principal. What investors hope when they buy premium MBS is that the rate of prepayment is more than offset by the above market coupon paid on remaining principal.

GSE Buyouts Set to Increase?

Currently the GSEs' buyout rules are written to allow them to buy a loan out of a pool if it is delinquent 90 days or more, but they are obligated to do so if it is 24 months delinquent. They also will buy it out of the trust if it is modified, a foreclosure sale occurs, or the cost of advancing P&I to pass-through investors exceeds the cost of holding the delinquent loan.

When loan performance degraded in 2007 and GSE capital came under pressure, both GSEs made operational changes that postponed those buyouts. When the pass-throughs were "off balance sheet" accounting for a buyout meant the GSE's passed the remaining principal balance to investors and then booked the delinquent loan at fair value, often taking an immediate 60 point loss on it, a direct hit to capital.

The game changes when the loans come back onto balance sheet. They will come onto the balance sheet at par. A buyout moves the asset into the investment portfolio at its carrying value (par), so no capital event. The cost of advancing P&I on delinquent loans is high – J.P. Morgan estimates it costs the GSEs about $15bn a year – cash they could save by removing the loan from the pool. However, a buyout uses cash and portfolio headroom. Hence, J.P. Morgan speculates Fannie and Freddie could sell pass-throughs into markets already fretting about the Fed's diminishing appetite.

Analysts are divided on the impact. For example, in a report last November, J.P. Morgan analysts estimated that buyouts and other kinds of liquidations in delinquent loans contributed about 10 constant prepayment rate (CPR) of a 25CPR prepayment rate in Fannie 6.5s for October. Given the actual degree of delinquency in higher coupons, they projected that prepayments could easily exceed 50CPR if delinquent loans were cleaned out all at once. On the other hand, Barclay's analysts expects accounting changes to make only marginal differences in GSE operations. Instead, they expect buyouts to be driven the HAMP and other foreclosure prevention and alternative processes already instituted with servicers.

What's the difference for prepayments? In simplest terms, timing. Most arguments in favor of a surge in GSE buyouts assume the enterprises will move quickly to clean up pools, which would result in a short dramatic increase in prepayments, followed by a return to the kind of slower-than-historical prepayment behavior that has attracted investors to the premium pass-through sector. Absent that surge, its clear from the buildup in HAMP pipelines, that the program should contribute a jump in prepayments during the first quarter, as trials convert to completions (a trial becomes permanent when two hurdles are cleared: documentation requirements are met and three consecutive trial payments are made).

The other sources of credit-driven prepayments are traditional home retention actions offered to borrowers who don't qualify for HAMP, foreclosures and foreclosure alternatives. The GSE regulator, FHFA, indicated in a November news release that these activities continue to increase. For example, home retention actions were up 32% in August (from July) and foreclosure starts were up 11%. Prepayments driven by these credit events could continue to rise long after the HAMP hump is past.