Swift action a boon for mortgage bonds (FT.com)
09.09.2008 01:10 Finance
The plan to take control of the two government-sponsored enterprises was announced by Henry Paulson, US Treasury secretary, and James Lockhart, director of the Federal Housing Finance Agency, on Sunday.
It eliminated investors' uncertainty as to what the mounting losses in the housing market would mean for the debt obligations of Fannie and Freddie and their role in the mortgage-backed securities market. Freddie and Fannie guarantee three-quarters of all new US mortgages and their securities are among the most widely held throughout the world.
"The risk was that Treasury would be slow to act and things would spiral out of control as foreign investors shied away from US debt," said Rajiv Setia, head of US agency strategy at Barclays Capital. "Instead, Treasury cut the ambiguity out. Treasury's actions will ensure that mortgage credit will remain available to homeowners who deserve it."
Mortgage rates fell sharply, with an index of the current 30-year Fannie Mae coupon dropping below 5.20 per cent from a close of 5.63 per cent on Friday. The extent of the move highlighted a lack of liquidity in the mortgage market and also caught existing holders offguard.
"What we have is a mad scramble for mortgage-backed bonds," said Arthur Frank, director of MBS research at Deutsche Bank Securities.
The big rally in mortgages was accompanied by a similar move in the agency debt issued by Fannie and Freddie.
"Generally, foreign accounts have viewed the intervention as at least a short-term positive for spread product," said TJ Marta, strategist at RBC Capital Markets.
The senior debt of the GSEs was quoted 25-30 basis points tighter across maturities but trading was very thin. Investors had long believed senior obligations would be protected in any government intervention.
Subordinated debt, where uncertainty had reigned as to where the Treasury would put its backing, tightened by hundreds of basis points, dealers said. Less than two weeks ago, for example, two to three-year subordinated debt was quoted at Libor plus 500bp and it was quoted at Libor plus 50bp on Monday.
The plunge in mortgage rates unsettled the Treasury bond market. Initially, Treasury yields jumped sharply as investors focused on the likelihood of greater debt issuance from the US Treasury to fund the GSEs.
However, the decline in mortgage rates upset the balance between portfolios of home loans and the general level of rates. When rates fall, mortgage portfolios often buy Treasury notes and interest rate swaps in order to keep their holdings properly hedged.
After the yield on the 10-year Treasury rose to 3.85 per cent, it was steady at 3.66 per cent late on Monday afternoon. "There has been a big need to buy Treasuries and swaps in order to hedge mortgage risk," said Rick Klingman, head of Treasury trading at BNP Paribas.
Credit Suisse estimates that the fall in mortgage rates since Friday translates into a hedging need of buying $215bn in 10-year Treasury and/or swap exposure. A further fall of 25bp will require $310bn in total hedging needs.
The 10-year swap spread was trading at 61bp on Monday, in from a close of 68bp on Friday.
Over time, though, Treasuries may come under pressure if the buying of mortgages from private investors falters. Such an outcome will compel the Treasury to step up its own purchases of mortgages, funded in part by the sale of government bonds.
As the initial relief trade closed out on Monday, propping up the two mortgage giants was not seen as being a panacea for all of the trouble in the credit markets.
"Near-term, it restores confidence in the financial/credit markets and is a positive for risk assets," said Mark Kiesel, a portfolio manager at Pimco. It did not resolve other long-term issues, he said, as the credit crunch in the private sector was just beginning.
"A more broad, deep credit crunch is still possible as the default rate rises," Mr Kiesel said. At the same time, the investor base is shrinking as Wall Street dealers, hedge funds and foreign investors pull back on investments as funding needs for refinancing and writedowns are rising.
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