The good ol’ days
Do you remember the go-go days in the first half of this decade? It was a rare day that you checked the mailbox and didn’t see an offer from someone telling you to refinance your house. It was so easy a caveman could do it. It worked all the way up to the point where the wheels came off the bus. The dual bubbles of housing and credit popped and it all grinded to a halt.
Borrowers lost their jobs, they struggled to repay loans, home prices plummeted, LTV’s were out of whack…we all remember the story. When the dust settled we were left with a landscape of shattered dreams. A lot of people dusted themselves off only to find that they owed a lot more on their home than it was now worth. Many others lost their jobs at the same time. Refinance opportunities dried up as credit scores and home values fell in tandem.
In that environment many people pushed the idea of buying high premium MBS because the risk of refinance-driven prepay activity was gone. We were not among that group…we bought discounts as long as we could. After all…the definition of “Risk” is that more things can happen than will happen. Why expose ourselves un-necessarily?
That was fine while it lasted but as rates dropped further it became almost impossible NOT to buy MBS at a premium…there were no coupons low enough to provide discount prices. Now even those investors who tried to avoid high premiums are forced to operate in a world that is filled with them.
It’s like a Boomerang
The refi story is like a boomerang…every time you think it’s going away it turns around and comes back…and you’d better be ready to duck.
This refi-boomerang story brings to mind one of what I suppose could be called “foundational phrases”. These are bits of wisdom that I’ve gleaned from people in my life over time. These nuggets are usually encapsulated in a catchy phrase that makes it easy for people like me to remember and digest. One example is from Major Lissner, USMC, who used to throw this phrase out a lot in times of pain and difficulty; “do you think anyone gives a “bleep” that you’re miserable?” I loved the phrase for its Spartan simplicity. It said “I care” and “I don’t care” all at the same time…it was brilliant.
But that’s not the phrase that comes to mind with regard to the mortgage refinance issue. The phrase I’m thinking of today is by coincidence from another Marine Corps officer who used to caution us that “If you run your butt up a flagpole it’s gonna get shot off”. It’s a bit of wisdom that at its most basic level addresses a topic near and dear to us…risk management. Years after I first heard the phrase I got to see the practical application. I was watching the news one night and they were covering one of the many riots in the Middle East when I actually saw a guy shimmy up a flagpole. Guess what he got…yep…shot. At that point I understood that this was a generally accepted principle and that I could rely on its wisdom going forward. So with that in mind I reflect on our current predicament…which is one of exposure…and how to not get our hind-end shot off.
Standby for impact
We’ve frequently discussed the impact that a wave of mortgage refinancing would have upon the economy. From our viewpoint the first effect would be that investors who purchased MBS at large premiums would be burned, secondly investors who purchased MBS at lower levels and rode them to gains would see those profits erode, and lastly it would put huge amounts of money into the pockets of homeowners which they could use to stimulate the economy. There are many other effects that would ripple through other areas but those are beyond the scope of today’s article.
The first two issues on the list above (those that affect investors) are likely to be considered collateral damage…few people outside of our industry will care that your yield burned down or that your bond accounting gains have disappeared. You will be viewed as greedy investors, and as Major Lissner used to ask “do you think anyone gives a “bleep” that you’re miserable?”
It’s the last item on that list that is the really shiny and attractive prize in this deal: money in the pockets of homeowners/consumers/voters.
Can they do it?
From the governments standpoint this has to appear to be an almost magical solution. By pushing and pulling on the levers of power they might be able to create a landscape where many of the hurdles to refinance are removed. This would allow a lot of capital to roll right into the pockets of spenders. This would in theory help to bring back the good ol’ days where everyone spent, everyone had a job, and there were no problems too big to borrow our way out of. All of this just a year before the election, what’s not to love?
A few things are clear. One is that the programs put in place thus far to “help” homeowners haven’t been nearly as successful as their creators had hoped. Next is that there is no shortage of people who would love to refi but can’t. Another is that rates are low enough to pull it off…you just need to bully the rest of the pieces into place. Lastly the incentive is there…people in Washington are getting desperate for some positive momentum in the economic data. Estimates of how much discretionary income would be created by pulling this off run well into the tens of billions of dollars per year.
One big piece of this puzzle is already in place…the Fed has driven rates to historic lows. Obviously this is not the only piece of the puzzle…many people can’t refinance because they owe more than the home is worth. Others are prohibited because they have a habit of paying people late, less than what they owe, or simply not paying them back at all. There are still hurdles that need to be cleared for this refi wave to take shape…but some of the important pieces of the foundation are there. The longer rates stay low the longer the government has to come up with a way to make this work. This is a concern that is stalking the markets currently.
What can you do?
In what has become an almost annual evolution in the investment world we are reviewing MBS holdings to determine which bonds are most at risk for negative yields based on refinance-driven prepay activity. We have created analytics that will identify bonds that hold the potential for negative yields based on your book price along with Bloomberg projected speeds and the actual speeds being posted by each bond.
This report can help you identify bonds that you might not be comfortable holding. The report can also provide some peace-of-mind if you discover that your portfolio doesn’t have the potential to deliver negative yields.
We run this report on a complimentary basis. If you would like us to run your portfolio just send me your latest bond accounting report and we’ll get it done. For those of you that are already on our bond accounting system just shoot me an e-mail and I’ll pull the data and get it done.
If you have any questions on this material or if there is anything I can be doing for you just let me know. Until then…don’t run your hind-end up a flagpole.
Steve Scaramastro, SVP
800-311-0707
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