As you probably know by now, the mortgage-backed security (MBS) market is looking to find new levels after almost 11 months of unprecedented stability in record-low territory. This “new” market action may come as a shock, but in many ways, it was expected. We just didn’t know exactly when it would happen.
Since the beginning of 2021, yields have been rising as bond prices have been dropping, with the biggest moves coming in the past week. At present, the UMBS 2.0 is down almost 3 points since Feb. 1. Consensus across the industry is that the massive reduction in COVID-19 cases, coupled with significant vaccination progress, has lit the path to pandemic recovery – and the markets are taking notice by shifting into post-crisis position. Expectations for higher employment, inflation and economic growth all point toward higher yields, which means higher interest rates, with mortgages as no exception.
However, there’s no need to panic in terms of your position or mark to market if your position is hedged neutral to the market. Current market volatility is not a reaction to a new crisis, like it was in March 2020, but rather changing market dynamics. The markets are trying to settle at new levels, which will almost certainly mean higher rates, and in the interim, there will be some volatility. Pipelines that are properly hedged are generally protected from this sort of volatility, though. Clients may want to run positions neutral as this remains the right posture during this shift.
As far as agencies and investors go, it seems unlikely that this market shift will have any negative effects on loan pricing relative to MBS, as we saw in March 2020. If anything, higher interest rates should lead to lower volume, higher servicing values, and thus, better overall competition among investors.
Volume, on the other hand will be a concern if rates continue to surge. As with any cycle in this industry, we will likely see volume slow as rates rise. This is an operational and financial concern that will be heavily discussed in the coming months; for now, let’s focus on current positions, new locks and selling loans.
From the Federal Reserve’s perspective, there is some desire for rates to rise, so this is not an unwelcome move in the market. Note, however, that the Fed certainly doesn’t want dislocation or extreme volatility. Thus, we can expect that the Fed will continue to monitor this situation and intervene as needed – just as it has been since mid-March 2020. We do expect Fed purchases to increase slightly, as the central bank attempts to temper the sell-off.
How to Proceed
As we would in any market, the focus should be on remaining neutral, selling loans when conditions are somewhat steady, watching liquidity, revisiting our assumptions regularly, and communicating.
If you are trading your own position, watch for coupon shifts and coupon liquidity issues. Right now, we are seeing loans shift into higher coupons, which is making positions shorter by way of low coupon (high beta/duration) short positions. If this sell-off holds and/or continues, we will likely be trading higher coupons, and should be focused on cleaning up low coupon coverage. Specifically, 30-year 1.5 coupons, which would likely be the first to show signs of poor liquidity, should be lifted sooner rather than later; 2.0s should follow if the slide goes deeper and longer. Also, watch the B/O spreads, which have been widening and tightening sporadically. Any time spreads are wide, seek more color before trading. And, definitely discuss specific position scenarios with your hedge advisor. Also, watch those low note rates; with anything under 2.25% on a 30-year, you may want to lock B/E, especially if you only have a few loans in this bucket.
Again, this is a dynamic we’ve not dealt with frequently in the last 11 months, but don’t forget to be diligent about repricing. Don’t wait for investors to change price. Rather, control the pricing that your loan officers and borrowers see to avoid being picked off in a sell-off.
While hedge models are equipped to handle market volatility, it is still prudent to revisit assumptions more often when faced with a major shift in the market, like the one we may be seeing take shape this week. If you use a third-party product for hedging, most necessary assumption changes may be automatically captured in your model, but lender-specific assumptions, such as pull-through, are worth reviewing. This is another topic you should discuss with your hedge advisor.
Also, lenders should plan for any cash considerations resulting from this market shift. In 2020, we were being paid handsomely for loans, resulting in large gain-on-sale (GOS) numbers, and we were paying our dealers monthly. If market trends continue, in Q1 2021 we will be receiving less in GOS, but receiving large payments from our dealers.
The February 2021 MBS market sell-off is not yet a seismic event, but we are all watching closely. As the market seeks its new trading range, think about keeping your positions flat, selling often, watching liquidity signals, and staying close to your hedge advisor.
More to come soon.
In case you missed it, you can still watch our recent Black Knight Crash Course on Evolving Market Conditions in 60 Minutes. Click here to view the full presentation.