Reverse

HMBS: Rough Waters in the Secondary Market

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

After several weeks of tightening spreads in early 2016, the HMBS sector is widening into mid-February as interest rates plummet and investors move back to the sidelines. Global macro themes, all negative, are putting pressure on spreads and dealer balance sheets. Oil, China, the lack of meaningful economic growth (everywhere), and the Federal Reserve’s focus on normalizing interest rates are among the issues plaguing the market. There’s talk of the United States entering—if it’s not already in—a recession, and Japan recently moved toward NIRP (Negative Interest Rate Policy). Japanese 10-year government bonds currently yield zero, and German 10-year government bonds currently yield .23 percent.

So, while the Federal Reserve raised interest rates 25 basis points in December amid a general calm in the markets, 2016 has been anything but calm. Major stock indices are off 10 percent, with large U.S. banks off anywhere from 15-30 percent (European banks are off 30-40 percent). Financial markets are in a major stage of tumult and upheaval as the market awaits more signaling and messaging from central banks on additional policy accommodation. I personally think the central banks are out of ammunition, and until there are fiscal policy changes and pro-economic-growth candidates surfacing, we will see more of the same (brief periods of euphoria before more plunges into the inevitable death spiral).

Fixed-rate HMBS (5.05 percent gross rate) is trading in the 113 dollar price area after widening 25 bps (in spread) during the latest interest rally down to 1.65 percent on the 10 year. Twelve-month indexed Libor, which comprises the largest share (85-plus percent) of originations, trades just shy of 110 dollar price for a 2.75 percent gross margin (85 percent PLU) and one-month Libor around 109 dollar price for a 2.75 percent gross margin (85 percent PLU).

Near term, I expect spreads to leak wider in interest rate rallies driven by negative global economic shocks. We’ve also seen dealer liquidity dissipate, which should pressure spreads in the intermediate term. All that being said, most if not all floating-rate HMBS and a large percentage of fixed-rate HMBS are being structured into HREMICs, so end-investor demand for the strips and interest-only classes will be another primary driver of spread directionality amid the atmosphere of chaos in the backdrop.

Prepayment speeds are supposed to benefit from the NRMLA ethical guidance regarding refinances. We’ve seen a very small impact thus far, though we hope to see a more meaningful impact in the February and March numbers. On the heels of the August 2014 announcement that PLF factors were being revised higher, prepayment speeds rocketed to levels never before seen in the history of the HECM program, causing irreversible damage to many investors in the program and broker dealers alike. While the NRMLA announcement was 12 to 18 months too late, let’s hope it works and originators adhere to it.

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