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Rates and the curveCreditMonetary policy

Mortgage-Backed Securities

Andreas Fuster, David O. Lucca and James Vickery, Federal Reserve Bank of New York (Staff Reports) · Feb 2022

Why it matters

Mortgage rates are priced off MBS, not the policy rate. This survey explains prepayment risk, negative convexity and the option-adjusted spread, the vocabulary of any fixed income or securitised products interview.

What it says

Three economists review the US agency mortgage-backed securities market, one of the largest and most liquid fixed income markets, with more than $11 trillion outstanding. Securitisation lets mortgages be held and traded by investors worldwide rather than kept on lenders' balance sheets. Investors face four risks: duration, prepayment, credit and liquidity. Because a borrower can repay at par with no penalty, refinancing rises when market rates fall, so the security shortens just as its price would gain: MBS are callable and show negative convexity. These risks are why MBS yields exceed those on Treasuries, and the option-adjusted spread, the constant spread over riskless rates that reconciles expected cash flows with the price after prepayments, is the standard measure of that premium. The spread also responds to supply, including Federal Reserve purchases. Finally, the authors explain why the prepayable fixed-rate mortgage makes monetary policy reach households less directly than adjustable-rate lending would.

What to take from it

  1. 1

    The option-adjusted spread to Treasuries on current-coupon agency MBS averaged about 50 basis points since 2000, spiked to about 150 basis points in autumn 2008 and turned negative at times during QE3 and QE4.

  2. 2

    Agency borrowers can repay at par without penalty, so prepayments rise and MBS duration falls when rates decline, capping price gains. This negative convexity is one of the risks for which MBS investors demand a premium over Treasuries.

  3. 3

    Event studies find announcements of new Fed MBS purchases brought significant declines in MBS yields and spreads, and MBS purchases moved MBS yields more than a comparable volume of Treasury purchases.

  4. 4

    US borrowers must refinance to benefit from lower rates, so policy reaches household balance sheets less directly than under adjustable-rate mortgages; limited originator capacity and high markups at peak demand blunt it further.

  5. 5

    TBA forward trading is about 90 percent of the $288 billion of daily agency residential MBS volume, and TBA eligibility is estimated to lower mortgage rates by 7 to 28 basis points.

Put it to work on L3VLUP

Original: Mortgage-Backed Securities, Federal Reserve Bank of New York (Staff Reports) (opens in a new tab)

The summary and takeaways are L3VLUP’s reading of the publication, not the publisher’s own words or views.

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