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Mortgage Bonds Pare Relative Drops Amid Worst Month Since 2008

Fannie Mae
The Fannie Mae headquarters building stands in Washington. Photographer: Andrew Harrer/Bloomberg

Fannie Mae and Freddie Mac mortgage bonds pared losses relative to Treasuries with the market for government-backed home-loan debt after heading for its worst month since 2008 at the height of the global financial crisis.

Fannie Mae’s 30-year fixed-rate mortgage securities with 4.5 percent coupons rose 0.13 cent on the dollar in comparison with U.S. government notes as of 4:45 p.m. in New York, after a relative drop of 0.39 cent yesterday that was the largest this year, according to data compiled by Bloomberg.

Mortgage bonds with government-backed guarantees had been on pace to underperform Treasuries by the most in a month since November 2008, when the U.S. response to the crisis sparked by other housing debt contributed to volatility, Barclays Capital index data show. Some investors are concerned that amid record low interest rates for certain mortgages the U.S. may change refinancing rules to help homeowners blocked by reduced home prices, tighter lending standards or financial distress.

“The recent debate about the government interfering with the mortgage market, and potentially ‘engineering’ a refi wave, has got mortgage investors spooked,” Brian Ye, a mortgage-bond analyst in New York at JPMorgan Chase & Co., said yesterday in an e-mail. “And now they’re on strike.”

While a new refinancing initiative would damage directly mortgage bonds with higher coupons -- such as Fannie Mae’s 6.5 percent securities that trade at more than 109 cents on the dollar -- by boosting prepayments that return investors’ money at par faster, it would also hurt lower-coupon debt into which the new loans may be packaged by increasing supply, Ye said.

Fannie Mae Securities

Because low-coupon debt hasn’t “repriced” as dramatically as higher-coupon bonds since July 1, investors should buy options to sell Fannie Mae’s 4.5 percent securities, backed by loans with rates averaging about 5 percent, as a way to “hedge refi related risk,” New York-based Citigroup Inc. analysts Brad Henis, Inger Daniels and Brett Rose said yesterday in a report.

Fannie Mae’s 4.5 percent bonds yesterday fell 0.02 cent more relative to Treasuries than on March 31, the day the Fed ended a program in which it bought $1.25 trillion of agency mortgage bonds to bolster housing and financial markets, according to Bloomberg data available from January. The company’s 6.5 percent bonds, whose underlying loans’ rates average about 7 percent, today gained 0.13 cent compared with Treasuries after a relative drop of 0.3 cent the past two days.

The Fed said Aug. 10 that it would buy Treasuries with repayment proceeds from its holdings of mortgage securities and agency corporate debt to help support the economy.

Fed Fallout

The Fed’s statement may also be hurting mortgage bonds because it made it appear less likely that the central bank will ever buy mortgage bonds again, after some investors anticipated any announcement on it reinvesting would include the debt, Jim Bianco, president of Bianco Research LLC in Chicago, said yesterday in a telephone interview.

“The Fed washed its hands of the mortgage market, that’s why it got killed,” he said. “They could have just as easily said they were going to buy mortgages, Treasuries and agencies.”

The $5.2 trillion of mortgage bonds guaranteed by government-supported Fannie Mae and Freddie Mac or federal agency Ginnie Mae have returned 0.39 percentage point less than Treasuries with maturities similar to the securities’ projected average lives this month through yesterday, according to Barclays Capital index data.

‘Very Disquieting’

That would be the worst month since they underperformed by 0.68 percentage point in November 2008, and the worst pace during a month since early May, when Europe’s sovereign debt crisis roiled markets. The debt ended up outperforming Treasuries in May by 0.02 percentage point as investors began seeing it as a safe haven with little credit risk, helping boost prices to records last month before refinancing concern rose.

“The very fact that they’re letting us twist in the wind like this is very disquieting,” Julian Mann, who helps oversee $5.8 billion in bonds as a vice president at First Pacific Advisors LLC in Los Angeles, said today in an interview.

It “suggests either they haven’t decided what their plan is or they may not really be very concerned about how this impacts savers, and our global creditors, nor what impact such an increase in duration may involve,” said Mann, who this week sold some agency mortgage bonds.

Morgan Stanley economist David Greenlaw, who fueled speculation over refinancing rule changes with a July 27 report calling it “slam dunk stimulus,” said in an interview yesterday that the Fed’s announcement may be signaling that it would be ready to engage in “large-scale asset purchases” if the economy worsens.

Low-Coupon Debt

Fed buying could be used to deal with the fact that such refinancing would boost the supply of low-coupon mortgage-backed debt with long-projected lives, or duration, in the fixed-income market, he said. That would potentially boost borrowing costs for everyone from the government and homeowners to corporations.

Greenlaw said he took the Treasury’s Aug. 5 response to a Reuters blog report as suggesting that “nothing along these lines is likely in the near-term.”

Yields on Fannie Mae’s 3.5 percent securities, which may most influence loan rates because they are trading closest to face value and are filled primarily with loans created in recent months, fell 0.05 percentage point today to 3.43 percent, after rising from a record low of 3.42 percent two days ago.

The average rate on a typical 30-year mortgage fell to a record low 4.44 percent in the week ended yesterday, down from 4.49 percent last week and this year’s high of 5.21 percent in April, according to McLean, Virginia-based Freddie Mac.

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