HMBS: Strong Performance Continues in HMBS

Written by Darren Stumberger, as originally published in The Reverse Review.

HECM spreads have tightened markedly into late February as investor appetite remains strong in this lingering low-interest-rate environment. Spread levels have evened out and are roughly the same as they were before the traditional year-end widening. Annual Libor bonds have tightened to 20 DM (discount margin) after widening out to 32 DM at the end of 2014. Fixed-rate bonds have tightened into the low 40s to swaps after touching out to the low 70s to swaps late fall and into December. Monthly Libor bonds are back to 40 DM after touching 60 DM late last year.

Demand remains strong from dealers and investors; I would not expect much change in sentiment as long as volumes remain depressed. With new capital charge rules and Basel III, domestic banks need to continue filling their portfolios with zero-risk weighted floating-rate mortgage-backed securities. Via HREMICs, dealers can create Ginnie Mae par-priced floaters at a spread of 50 basis points above the funding cost (usually one-month Libor) and can take comfort that if rates rise, the asset will move in lockstep with the funding cost. Most notably, banks usually like to own assets that won’t extend in duration as rates rise. Typically with forward MBS, as interest rates rise, bonds will extend in duration as fewer borrowers try to refinance their mortgages. This in effect slows prepayments and extends the weighted average life of the security. Banks don’t like that, as it creates a mismatch of their assets and liabilities. With an HREMIC class, these fears are alleviated due to the fact that higher levels of interest rates cause the 98 percent buyouts to occur sooner and actually create a slight contraction of spread duration in this scenario. So, banks pick valuable spread over comparable government-guaranteed investments alternatives and the lack of extension risk makes the asset a core focus for banks.

Through mid-February 2015, issuances have totaled $1.25 billion, which indicates an increase of 15 percent from 2014. Program-to-date issuance has reached $56 billion. Directionally speaking, the industry has issued roughly the same number of loans (including tail balances) in the past seven years versus the prior 18. In 2015, the biggest driver of increased volume has been an uptick in tail issuances, particularly from late 2013, because of early 2014 HECM 60 pools where borrowers could draw on their lines of credit after the 12-month freeze. Interestingly enough, the draw behavior is orderly and only modestly above historical monthly draw patterns. By no means are borrowers drawing the rest of their funds at their expiration date. We’re seeing some minor pent-up demand for funds come through (as one would expect), and then normalization back to historical patterns. The behavior seems rational and in line with the intent of the Reverse Mortgage Stabilization Act of 2013.

In regard to volume, we will see a front-loading effect as borrowers may opt to hasten their decision to take out a HECM prior to the implementation of Financial Assessment. This is certainly not a new phenomenon as this trend usually occurs prior to a program change. If anything, it simply front loads volume and steals from later months. Net-net, you get to the same place.

One notable trend in originations is the increase in adjustable-rate loans indexed off of the 12-month Libor. Whereas annual Libor origination only comprised 15 percent of adjustable pools originated in 2014, the percentage of 2015 originations is growing rapidly. I’d almost expect a complete flip-flop of the 85 percent to 15 percent breakdown (one-month Libor versus 12-month Libor) that we saw in 2014, with annual taking on a much higher percentage in 2015. This is very good news, as the annual loan is an excellent choice for the consumer concerned about rapidly rising interest rates.

3d rendering of a row of luxury townhouses along a street

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