Mortgage Bonds Slump on ‘Mega-Refi’ Concern: Credit Markets

PIMCO Co-Chief Investment Officer Bill Gross
Pacific Investment Management Co.’s Bill Gross urged government officials to allow all borrowers who haven’t missed payments on Fannie Mae and Freddie Mac loans to get lower-cost mortgages. Photographer: Andrew Harrer/Bloomberg

Government-backed mortgage bonds are underperforming Treasuries by the most this year, after reaching record high prices, amid concern refinancing will accelerate.

Fannie Mae, Freddie Mac and Ginnie Mae securities have returned 24 basis points, or 0.24 percentage point, less than U.S. debt this month, the worst relative results since December, Barclays Capital indexes show. Fannie Mae’s 6.5 percent bonds fell to 109.06 cents on the dollar as of 11:30 a.m. in New York, declining even as Treasuries gained from the high of 109.94 cents on July 27, according to data compiled by Bloomberg.

Record-low interest rates for new mortgages may entice borrowers to refinance, led by those with newer loans, as applications hover at the highest in more than a year, according to the Mortgage Bankers Association. The inability of some homeowners to qualify for new Fannie Mae and Freddie Mac loans is raising speculation the U.S. will loosen rules, punishing more bondholders as higher yielding mortgages disappear.

“Why are you going to believe the government is going to continue to pursue a policy that favors investors over homeowners?” said Doug Dachille, chief executive officer of New York-based First Principles Capital Management LLC.

Pacific Investment Management Co.’s Bill Gross urged government officials today to allow all borrowers who haven’t missed payments on Fannie Mae and Freddie Mac loans to get lower-cost mortgages. Dachille, who oversees about $8 billion of fixed-income investments, supported the idea yesterday in a telephone interview, saying such financing should be offered without consideration of homeowners’ incomes or house values.

Default Swaps Fall

Elsewhere in credit markets, the extra yield investors demand to own company bonds instead of government debt was unchanged at 177 basis points, according to Bank of America Merrill Lynch’s Global Broad Market Corporate index. The spread has widened from this year’s low of 142 basis points on April 21, and narrowed from 201 basis points on June 11. Yields averaged 3.523 percent, the lowest this year.

The cost of protecting corporate bonds from default in the U.S. and Europe fell to the lowest in a week. The Markit CDX North America Investment Grade Index Series 14, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, declined 3.61 basis points to a mid-price of 106.98 basis points as of 12 p.m. in New York, according to Markit Group Ltd. In London, the Markit iTraxx Europe Index of credit-default swaps linked to 125 companies with investment- grade ratings, fell 5.51 to 109.45, Markit prices show.

The indexes typically drop as investor confidence improves and rise as it deteriorates. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Not ‘Panicked’

Mortgage-bond investors are looking for signals on what the government may do as the Treasury Department and Department of Housing and Urban Development host a conference today in Washington on how to repair the system, said Steve Kuhn, who helps oversee about $750 million of investments in the securities for Pine River Capital Management LLC in Minnetonka, Minnesota.

The future of Fannie Mae and Freddie Mac, which regulators seized in 2008, is being discussed at the meeting. While the market isn’t “panicked,” investors are worried that “the threat of a mega-refi event is still out there,” Kuhn said.

Gross, who runs the world’s biggest bond fund at Newport Beach, California-based Pimco, said at the conference that “policy makers should quickly engineer” refinancing of Fannie Mae and Freddie Mac loans to bolster the economy. Treasury Secretary Timothy Geithner and HUD’s Shaun Donovan didn’t address the issue.

Returning Cash

“The American economy is approaching a cul-de-sac of stimulus, both monetarily and fiscally, which will slow it to a snail’s pace” and will require a new boost within the next six months, Gross said. His Total Return Fund is 18 percent invested in mortgage debt, a lower share than found in benchmark indexes.

Prepayments on mortgage bonds trading for more than face value punish investors by returning their cash more quickly at par. The $5.2 trillion market for agency mortgage securities, guaranteed by Fannie Mae, Freddie Mac or U.S. agency Ginnie Mae, fuels almost all new home lending after the collapse of the non-agency market in 2007 and a retreat by banks.

The average rate on a typical 30-year U.S. mortgage has fallen to 4.44 percent after declining in seven of the past eight weeks, according to McLean, Virginia-based Freddie Mac.

‘Moribund Housing Market’

Gross said that loan rates would be “hundreds of basis points higher, creating a moribund housing market for years” without government-guaranteed bonds, and that he wouldn’t buy securities without such backing unless they contained loans with 30 percent down payments.

He called ideas that would provide taxpayer-backed reinsurance on Fannie Mae and Freddie Mac securities without nationalizing the companies to be “clones” of the model that ended up leading to the need for their bailouts. Mortgage-bond pioneer Lewis Ranieri, speaking on a different panel, said that the reason Fannie Mae and Freddie Mac financed too many risky mortgages stemmed “much more” from the companies’ “profit motive than any political motive to expand homeownership.”

A Federal Reserve plan announced Aug. 10 to buy more Treasuries to restrain borrowing costs as the economy struggles is also “feeding the fire” of concern about refinancing levels, said Bryan Whalen, co-head of the mortgage-and asset- backed bond group at Los Angeles-based TCW Group Inc., which oversees $115 billion. Loan rates remaining low is fanning investor concern the supply of low-coupon mortgage bonds filled with new loans will jump, hurting such debt, he said.

Absorbing the Supply

“This is the first time in a long time that the private market is going to have to absorb all of the current-coupon supply,” Whalen said in a telephone interview, referring to the Fed’s purchases of $1.25 trillion of mortgage bonds under a program that ended March 31.

Yields on Washington-based Fannie Mae’s 30-year, fixed-rate current-coupon securities, or those that most affect loan rates because they’re trading closest to face value, fell to a low of 3.39 percent yesterday, from this year’s high of 4.67 percent on April 5, Bloomberg data show. Yields rose to 3.45 percent today. The difference between yields on the debt and 10-year Treasuries has widened to 81 basis points, from 62 basis points on Aug. 9.

Refinance Plan

The federal Home Affordable Refinance Program, established in February 2009, created 291,600 loans through March, short of a target of 4 million to 5 million, according to data from the Federal Housing Finance Agency. The program was intended to allow more refinancing among loans approaching or exceeding borrowers’ property values, if Fannie Mae and Freddie Mac already own or guarantee their debt.

Borrowers find it difficult to refinance if their loans are more than 125 percent of their property’s value, they lack sufficient income and asset documentation, or hold mortgage insurance and are barred from rolling forward their policies unless they deal with their current servicers, according to lenders such as Quicken Loans Inc. and Equity Now Inc.

Drawbacks to looser rules for mortgage borrowers would include the damage to investors, their resulting caution and the potential for higher borrowing costs for the everyone from home buyers and the government to companies as more longer-duration debt reaches the market, according to First Pacific Advisors LLC’s Julian Mann and analysts at Barclays Capital and Nomura Holdings Inc.

“I don’t like rules changing on me, but rules have been changing on me for the last few years,” said Dachille. “Let’s look at the rule changes we’ve given to people who have been less-than-responsible. If you have a person who’s shown a propensity to pay, he should be getting a benefit, too. And, if the economy grows, we’ll all be better off.”

James Camp, who helps oversee $17 billion of assets as managing director of fixed income at Eagle Asset Management Inc. in St. Petersburg, Florida, last month sold his holdings of mortgage bonds that were at almost 110 cents on the dollar.

The recent decline in prices “is partly just the euphoria subsiding,” Camp said.

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