As modification efforts at the government-sponsored enterprises (GSEs) Fannie Mae (FNM)
and Freddie Mac (FRE)
pick up, prepayment speeds within agency mortgage securities increase, potentially funding more investments in agency collateral.
The system, as it stands, creates a cyclical cash flow from pay-downs when the loans are bought out of mortgage-backed security (MBS) trusts to bondholders that reinvest in other agency MBS. In other words, cash travels from the agencies, through buy-outs, to MBS investors and back into agency MBS.
Several factors support the system, beginning with the GSEs' push to implement the administration's Home Affordable Modification Program (HAMP). As HousingWire previously reported
, Fannie and Freddie implemented 405,700 active HAMP trials and permanent loan modifications as of Nov. 30, 2009, according to a report from the Federal Housing Finance Agency (FHFA). The trial modifications eventually lead to higher prepayments within MBS, as mortgages are bought out to be permanently modified.
Fannie and Freddie also stepped up efforts to buy out loans 120+ days delinquent -- a cost-reducing practice, as these mortgages are more expensive to hold in securitization, with guarantee payments to security holders and interest advances -- and instead hold them in mortgage-related investment portfolios. The delinquent buy-outs also give the GSEs greater flexibility to modify loans.
Fannie said last week it expects to purchase from 150,000 to 200,000
delinquent loans out of single-family MBS trusts during March. Freddie said in mid-February it would buy “substantially all” of its $69bn
of 120+ day delinquent mortgages.
But the buyouts – and the higher MBS prepayment rates triggered by them – could also be fueling additional investments in Fannie and Freddie collateral, according to Daniel Leland, executive vice president of Dallas-based Southwest Securities Group (SWS)
As a board member of the Regional Bond Dealers Association, Leland also runs the taxable fixed-income division at SWS. He says prepay speeds “increased quite a bit” as the agencies stepped up their efforts to buy out delinquent mortgages – which can then be modified.
“With the loan modifications, [Fannie and Freddie] are paying off delinquent loans at par, returning principal to the investor,” he says. “That money goes back to the folks holding the securities, who turn right back around and put it back into Fannie or Freddie collateral.”
The buyouts signal agency MBS investors could see their net investment decline, according to commentary in February
by Moody's Investors Service
But the buyouts have the knock-on effect of leading to increased demand for agency MBS, according to commentary last week by Matthew Jozoff at the JP Morgan Securities
fixed-income strategy team.
"There has been a great deal of anticipation of reinvestment demand from the buyouts," Jozoff and colleagues wrote in weekly commentary on securitized products. "Indeed, we’ve been approached by a number of investors (and traders) who are convinced that the cash being distributed will be reinvested into their sector, whether it’s agency CMOs, non-agencies, corporates – the list goes on."
He added: "Our view is that while these other sectors may benefit to some extent, the vast majority of the reinvested cash will go back into agency MBS, since these investors likely have specific credit constraints and duration targets."
Write to Diana Golobay
Disclosure: The author holds no relevant investment positions.