The next scary story
We have maintained over this entire cycle that if the government wants something then the government will get it. It goes in the same category as “you don’t spit into the wind, you don’t pull the mask off the ol’ Long Ranger and you don’t mess around with Slim”. This outlook is the primary reason that we have cautioned everyone away from high premium MBS as long as we could. The longer the final maturity and the higher the premium the less we liked it. When most of the world was squawking that “nobody can refi so there is no risk in big premiums” we took a more cautious, and I believe a bigger picture view. It has been our belief that there are more risk factors at work in this market than the normal, easy to predict factors. Once the government gets involved there is a huge wild-card at play…and it’s terribly difficult to figure out how the card will be played.
We are beginning to hear of a new push by the government to ignite a refi wave. The idea behind this strategy is nothing new…refi’s will lower monthly payments which will put more money in consumers’ pockets and also reduce the rate of foreclosures which will in turn help home prices in general. What’s not to love? While I try not to involve politics in any of these write-ups I would be remiss in my duties if I didn’t point out that this idea is being pushed just a short time before a very important election cycle.
The idea to get refi’s going has been an ongoing theme with the Fed and the Administration. Thus far it has been difficult to implement despite some very drastic efforts. The current idea that is being kicked around is that the GSE’s will waive or provide for much more lenient LTV and FICO requirements which will make it a slam dunk to get refi’s going.
If this happens prepays will go through the roof on longer final/higher coupon MBS. This means a few things for investors.
1 – If you bought high coupon MBS at lower premiums a few years ago you have big gains. These gains will quickly evaporate as the market shifts toward expectations of the refi wave…the bid will go away on your bond.
2 – If you bought the high coupon MBS more recently…and therefore at a huge premium…then you could be introduced to negative book yields as you are forced to burn down that premium over a very short time horizon.
3 – Yields on available lower coupon MBS will likely drop as a massive wave of refi generated cash flow is reinvested into the sector.
What should you do?
There are two answers here.
First…if you don’t think this will happen…then you don’t have to do anything.
Second…if you fall into the camp that does see this happening then you’ll want to take some action in advance. The first thing to consider is selling bonds that are in the strike zone so you can capture gains rather than let the market erode them as prepay expectations get priced in. It would really stink to be in a “rates unchanged” environment yet watch the “unrealized gain” section of your bond accounting report drop like a rock.
If you recall a few months ago when the GSE’s decided to clear the “log jam” of late pays in their pools, prepays spiked and traders quit bidding bonds. There was a period of time where you couldn’t sell your MBS. Someone might throw out a low-ball bid that was several points below market but the reality was that you had two choices… get scalped or don’t sell. It was an anxious month.
OK so I sell…now what?
The next issue is what to go back into. I would think that the most popular route (based on current market activity) would be to refinance into Full Faith and Credit, low coupon ARM structures. If you do this before everyone rushes for the door you will get both the benefit of higher prices on the sell side and higher yields on the buy side.
These aren’t great choices…but you can’t hope for much better given that the plan itself is a terrible idea.
It’s important to note that this is not a done deal yet. Portfolio managers will have to make their own determinations as to whether this plan will come to fruition or if it will die in the planning stage.
Once you make the first decision as to the probability of occurrence you can begin making plans for your next move. If the refi wave comes history will record two types of investors…those that got out of the way early and those that got crushed.
If you would like us to help you identify and monitor bonds that may be in the strike zone just shoot us a copy of your most recent bond accounting report. We have the analytics to quickly identify bonds that are likely to be exposed to this event and we can quickly provide swap ideas to remove you from harm’s way.
If you have any questions on this material or if there is anything I can be doing for you please let me know. I’ve included links to two stories on this topic for reference.
http://www.investors.com/NewsAndAnalysis/Article.aspx?id=117087239&source=Newsfeed&Ntt=Slam
Steve Scaramastro, SVP
800-311-0707
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