With fixed-rate spreads tighter on the order of 50 basis points, the HMBS market has reached all-time tights in spread and dollar price. The previous tights were set in late spring 2010 after we saw fixed spreads tighten from 120 to swaps to 60 from December to April. Currently, new issue fixed-rate HMBS trades at 55 to swaps for corporate settlement. Floating-rate HMBS has tightened 30 basis points, also reaching all-time tight levels.
There are several reasons for the tightening trend, but the primary reason is the announcement of the third round of quantitative easing (QE3) by the Fed (not including Operation Twist). With the Fed buying roughly 70 percent of newly originated forward mortgages, spreads on forward mortgage products have tightened dramatically. Generally, in mortgage products investors analyze the amount of spread they will earn over the risk-free rate by valuing the embedded prepayment option. Currently, coupon forward mortgages have a negative 50 basis point (prepayment adjusted) spread!
As we know in HECMs, refinances due to rate movement are few and far between, so when we quote fixed-rate HMBS spreads at 55, we consider that the nominal spread. However, because there is generally muted unscheduled prepayment activity, we typically assume the nominal spread is roughly the same as the prepayment adjusted spread. So, in this example, there is roughly a 100 basis point pickup in HMBS versus forward mortgages. It should be noted that other, more liquid asset classes, such as Agency CMOs and Agency CMBS, have also tightened and HMBS still trades cheap compared to these competing alternatives. The future of QE3 is very much uncertain as Chairman Bernanke’s future is uncertain and depends in large part on the Nov. 6 election.
Another driver of spread tightening has been what we like to call the structured or CMO bid. HREMIC issuance picked up substantially over the summer and through the fall, and while close to 100 percent of floating-rate HMBS is structured into a par-priced floater and interest-only class, an increasing amount of fixed-rate HMBS is being structured now. We saw a similar trend in 2010 when dollar prices rose to record levels and lower-priced, fixed-rate bonds were created with interest-only classes. New structures are being formed to tailor offerings to new investor preferences and a good portion of the recent tightening can be attributed to this development. Aside from newly originated HECMs being securitized and sold into the marketplace, there has been a perk up of secondary bonds trading (several hundred million weekly). With more than 40 billion of paper outstanding, it’s natural to see money managers, hedge funds and banks take profits after a run-up in prices like this.
Aside from day-to-day market action, there are several themes that will dictate where we are headed in this industry. The accounting (true sale) issue plaguing issuers remains a huge concern with a fairly uncertain outcome. A best-case scenario would be minor program changes and some re-working of the legal documents to pacify the Big Four accounting firms and the SEC. There are program changes being contemplated by FHA (as communicated by FHA members at the recent NRMLA conference). There seems to be a clear objective to reduce the amount of fixed-rate standard loans being originated. What the end result and industry volumes will look like after these changes is anyone’s guess. A best-case scenario here would be
some redirecting of fixed standard borrowers to floating-rate and saver loans with no material negative hiccup in volumes measured on a unit basis.
Financial assessment continues to be worked on with no clear implementation date set yet, and one can imagine the CFPB will increasingly focus on the sector with perhaps new rules to be implemented. News of Ocwen and Walter Investment Corporation entering the space can be seen as positive news. With the exits of the Big Three, the entrance of larger, well-capitalized institutions in this fragile industry is very much welcomed. There should be more announcements in the upcoming months as financial institutions clearly see the value proposition in offering the HECM to seniors and the growth prospects of the marketplace. The origination and issuance landscape will continue to evolve in this very interesting time for the industry, but a primary question I have is what or who will begin to drive penetration rates higher among the borrower base. I entered this industry in 2006 and penetration rates were roughly 1 percent. Almost seven years later we are at maybe 2 percent, and one can make the argument that fewer loans will be made in the near to intermediate term. As I’ve said in this column, the only constant in this industry is change. I would welcome a change in market penetration rates and would hope our trade organizations and origination community would be proactive in delivering fact-based, positive messages to media outlets and decision-makers in Washington.