Chris catches up on the latest news from the financial markets, including the results from the June Federal Open Market Committee (FOMC) meeting. He also begins a series on the basics of residential mortgage-backed securities (MBS) and collateralized mortgage obligations (CMOs).
Welcome to Bond Investment Mentor! This is a podcast dedicated to helping community financial institutions master the art of fixed income investments.
In this episode:
If you have questions about anything covered in this episode, please email me at Chris @ BondInvestmentMentor.com.
Do you know someone who could benefit from this information? Please share this episode and podcast with them!
You will find more articles, tips and resources about fixed income investing and portfolio management at BondInvestmentMentor.com. Check it out!
Let’s Connect via Social Media!
LinkedIn: Christopher Nelson, CFA
Facebook: Bond Investment Mentor
Bond Investment Mentor Episode Five.
[Music Intro]
Hi there, welcome to Bond Investment Mentor! I'm your host, Chris Nelson, and this is a podcast dedicated to helping community financial institutions master the art of fixed-income investments. If you're working for a community bank or credit union, and you have responsibilities for the investment portfolio, you've come to the right place! I'll be your personal investment guide as we help you boost your fixed-income investment knowledge, level up your portfolio management skills, and help you gain the know-how you need to help your institution achieve its financial goals.
In this episode, we'll catch up on the latest news from the financial markets, including the results from the Federal Open Market Committee meeting. And I'm also going to cover the basics of mortgage-backed securities. I've had a lot of requests to cover this topic. So, this episode is going to be the first of a series discussing residential mortgage securities and CMOs. We've got a lot to cover today. So, let's get started!
[Music Out]
Welcome to another episode of Bond Investment Mentor, I hope that you're doing well. And I'm glad you decided to join me today. The warm weather has finally made it to Maine, I wasn't sure if we were going to see it. I was worried we might have winter right through the summer. But no, actually the weather has warmed up. We've had a really pleasant spring and I’m looking forward and hoping that the weather stays like this through the summer, it would be nice.
So let's start off by talking about some of the latest news that we've seen in the financial markets. It has been a very busy week. First of all, let's talk about the Fed. This week, the Federal Open Market Committee wrapped up a two-day meeting. As expected, they left overnight rates near 0%. And most FOMC members projected that they expected short-term interest rates to remain at current levels through at least next year, and possibly into early 2022. So, it's going to potentially stay this way for a while.
The other thing that came out of the meeting is that they're planning to maintain current Treasury and agency mortgage-backed purchase activity at least at current levels. And for those of you that are keeping score, that's $80 billion a month in Treasury securities and $40 billion per month in mortgage securities over the coming months. And after the meeting, Federal Reserve Chair Jay Powell made it clear that the Fed is staying on the offensive.
Jay Powell: “At the Federal Reserve, we are strongly committed to using our tools to do whatever we can, and for as long as it takes, to provide some relief and stability to ensure that the recovery will be as strong as possible, and to limit lasting damage to the economy.”
And so at this point, we've got a couple of tools in use. We've got forward guidance; they have made it very clear what their expectation is for short-term interest rates. And I think it's safe to say that the temporary emergency purchase activities have definitely moved into the category of full-time quantitative easing. And so we've got two tools in use. Right now, we've got QE, I've lost track of which number we're at, and the forward guidance.
One of the things that I found very interesting after the meeting broke up, Federal Reserve Chair Powell held his usual press conference, and one of the questions that were asked was, you know, what if things turn out better than expected? Would that change the Fed’s thinking? They're talking about keeping rates really, really low. But if things turn around, does that call into question that kind of an outlook, and I found Powell’s comments very specific on this situation.
Jay Powell: “You know, we're not thinking about raising rates, we're not even thinking about thinking about raising rates.”
So, I think we pretty much know where the Fed chair’s head is with respect to any changes to interest rates in the near term.
So the 10-year Treasury rallied following the FOMC announcement on Wednesday. It had hit a high of 0.96%, the previous week, right after the employment report. We'll talk about that here in just a few minutes. But it did trade down to 0.73% and then moved lower in the coming days after the FOMC meeting. So basically, bottom line, no surprises in the announcement. The Fed outlook still appears to be cautious and they're not assuming that the strong May employment data will necessarily turn into a trend, but they'll be keeping an eye on it.
Something else that Powell talked about is he said that the committee had received a briefing on something called Yield Curve Control. There was no mention of it being used right away, but some analysts are expecting that the idea will be implemented possibly later this year.
We've already heard that the Fed has no interest in negative interest rates and if they have to go there, they will be used as the last resort. The feeling is, is that it's hard to get out once you've gone in. And experience has shown elsewhere that negative rates didn't achieve what they had hoped for when they were used. Now, this doesn't mean they can't happen. Despite the Federal Reserve's best intentions, the bond market could make negative interest rates a reality under the right or wrong circumstances just through activity in the markets. But let's leave negative rates alone. And let's take a look at Yield Curve Control. What is that exactly?
Well, under Yield Curve Control, the Federal Reserve would commit to buying whatever amount of bonds the market wants to supply at a target price through its open market operations. They do those through the New York Fed. Basically, they would target or peg a rate for a given maturity, let's say three or five years for example, and they would purchase bonds, effectively placing a cap on the interest rate at that part of the yield curve.
This isn't something new. The Fed actually pegged Treasury rates back during World War II for a time and other central banks have used Yield Curve Control, including the Bank of Japan, which began a policy of targeting 10-year government bond rates in 2016, at 0%, by the way. More recently, the Australian Central Bank has also done this. They adopted a form of Yield Curve Control by targeting three-year rates, in March of this year in response to the Covid-19 pandemic. Sage Belz and Dave Wessel from the Brookings Institution published a good article that discusses Yield Curve Control in a little more detail, why it matters, the associated risks, and lessons that can be learned from it. It was a great read, and I'm going to put a link to the article in the show notes if you're interested and want to learn more.
So, in other economic news, let's catch up on some other things. I mentioned the employment report earlier. This was a big deal when it came out. Economists were expecting that the May jobs report was going to show a loss of 7.5 million jobs. And boy, no one saw this coming! Instead, the Bureau of Labor Statistics reported a gain of 2.5 million jobs. The unemployment rate was expected to rise from April but instead, it dropped from 14.7% to 13.3%.
Now there was a story in the news about a glitch in the data. This is something that had happened with both the April and the May reports, there were just some adjustments that needed to be made. And the Bureau of Labor Statistics was very upfront about what the adjustments were based on and why they needed to happen. If you adjusted the previous two months' numbers, April's unemployment rate would have been close to 20%, not the 14.7%, while May's unemployment rate would have been about 16%, not the 13.3% that was reported on the headline number.
Now we still have a ways to go on the employment front but it was good news nonetheless, seeing folks coming back to work. As businesses started to open up again and certainly seeing the unemployment rate drop from whatever the number was in April, pick your number 20% or 14%, dropping down to 13% or 16%, but it was good news. And I'm cautiously optimistic hoping that the trend continues in the coming months ahead. We'll have to wait and see what happens.
Now, as I mentioned earlier, the effect on the yield curve, the 10-year sold off. It was kind of a surprise. We saw yields on 10-year Treasuries shift higher to 0.96% before pulling back this week after the Fed meeting.
The yield curve steepened. The 2s-10s spread, which is the difference between two-year Treasuries and 10-year Treasuries, just a common measurement, had risen up to almost 70 basis points. So we're back down around 50 to 55 basis points, which is still the steepest in about two years.
Now, related to this, I want to share with you an article that I came across. It was written by Bloomberg's Joe Weisenthal and discussed recent employment trends. And in the article, he talks about why the economic data, especially the employment data, is really confusing right now. And what he looked at - and I thought was a neat comparison- he used a variation on the “double curve” chart that we saw in the early days of the pandemic. I don't know if you remember that one where they were first talking about flattening the curve, and you had that double curve. There was the steep curve on the front end and then the flattened curve that went out a little bit longer. He taps into this idea, and in a similar fashion. He explained that there were two employment curves in play.
The first employment curve is the steep one, and this is the one that was created by the temporary unemployment resulting from the shuttering of the US economy as everything just closed down. The second curve, which isn't as steep, but it does go out longer, represented those jobs that were lost in the wake of the slowdown, and the economic damage brought on by the virus and the lockdowns. And so, you take both these curves and put them together, and the result is some crosscurrents in the labor markets, with some signs of improvement while other parts of the economy have just entered a more challenging period and one that could last for a while. I thought it was an interesting perspective, and it's definitely going to be a trend worth watching. I'll add a link to the story in the show notes so you can check that out, as well.
And then finally, I just wanted to touch on an article that came out recently. The National Bureau of Economic Research announced this past week that the US had entered into a recession in February. The National Bureau of Economic Research, the NBER, is the group that is the keeper of economic business cycle data. And in their announcement, they said that the unprecedented magnitude of the decline in employment and production, and its broad reach across the entire economy, warrants the designation of this episode as a recession, even if it turns out to be briefer than earlier contractions.
Normally, we don't get an announcement from the NBER until six to twelve months after a recession has started. So to have them make this announcement so quickly, calling a February recession just a few months later, it's unusual. But the committee, as I said, said that the speed and depth of the downturn made it easier to make a call sooner. The NBER also noted that there was a possibility that this recession might be briefer than previous ones, given the unusual circumstances that brought us here. So that's a quick look at some of the big news affecting things in the financial markets.
[Music]
So let's get into our main topic today on mortgage-backed securities. I've been talking with bankers recently and I've been asking them what they'd like me to cover on the podcast and I keep hearing over and over again, “please talk about mortgage-backed securities and CMOs, we'd really like to know more.” Now, there's a lot to cover on this topic, so I am going to break it up over the next several episodes. And in today's episode, I'm going to do an introduction, kind of covering the overarching concepts and key terms to lay the groundwork for future episodes.
So, let's start at the beginning. What are mortgage-backed securities? A mortgage-backed security is created through the pooling and securitization of mortgage loans. The bonds are issued by federal agencies such as Ginnie Mae, or Fannie Mae, or Freddie Mac. They can also be issued by private entities that aren't affiliated with the agencies and we refer to those as private-label mortgages.
And there are different types of mortgage securities. The plain vanilla variety made up of residential mortgage loans are referred to as pass-through securities or pass-throughs. Collateralized Mortgage Obligations, or CMOs - we'll cover those in a future episode - are a variation on residential mortgage bonds. Commercial Mortgage-Backed Securities, or CMBS, are mortgage securities that result from the pooling or the securitization of multi-family properties, we'll talk about those as well. And then there's Home Equity Conversion Mortgages, otherwise known as HECMs. These are securities that are created from reverse mortgages. So, those are your four basic types of mortgage securities.
We're going to speak today about residential mortgage securities, and they come in all different kinds of structures. Basically, if it can be originated, there's probably a securitized version available. And so you'll find fixed-rate residential mortgage-backed securities with 10-year structures, 15-year, 20-year structures, 30-year structures. You'll also see adjustable-rate mortgages, also known as ARMs. These are securities where the rates are fixed for a certain period, and then they'll float tied to an index. It was Treasury and LIBOR, and it's heading now just toward SOFR, or, you know, Treasury-based pricing because of the LIBOR sunsetting that's going on.
There are different ways to purchase mortgage-backed securities. If you just want to go out and get the latest one off the line, that's referred to as TBA. It's the To Be Announced market, it's new production. Or you can go out and purchase seasoned mortgage pools. These are mortgage securities where they've been in the market for a while and they're out there and so they've seasoned a bit and you can purchase those, as well.
So let me give you an example of how this works, this pooling of loans into the security. Let's assume that we have a group of residential mortgage loans that have an average coupon of 3%. Those loans are going to be pooled together by an agency, let's say in this example, it's Freddie Mac. And so they're going to take those loans, they're going to push them together into one security.
Now, the principal and the interest income are going to flow through to the investors. But there are going to be two things deducted from that interest income before the investor receives a penny. The first thing that's going to be deducted is the servicing fee. For those of you that work for financial institutions, if you do servicing on your loans or servicing on loans that you've sold, you know what I'm talking about. But this is paying for the party that is responsible for taking care of the processing of the mortgage payment, any escrows that might be involved, and so forth. That's the servicing fee.
The second thing that's deducted from the interest income is the agency guarantee fee, the “G-fee.” And what this is, is basically the insurance payment that is going to provide the coverage from Fannie Mae, or Freddie Mac, or Ginnie Mae, that if a borrower goes into foreclosure, the investor is going to be made whole. In other words, the agency will step in and pay you back on the principal that's due at that point. Both the servicing fee and the guarantee fee will reduce the pool coupon compared to the loan coupons. So that's where you'll see a difference when you're looking at a mortgage-backed security. And then as monthly mortgage payments are made, the principal and the interest are passed through, hence the term “pass-through” to investors. And each investor receives a proportionate share to the amount of the pool they own. If you purchase 10% of the mortgage pool, and the principal and interest flow through, you're going to receive 10% of it, it's all proportionate.
So that's a quick example of how a mortgage pool is created and built. Now let's talk about some key terms that are important to know, as you're working with mortgage securities. The first one I want to talk about is the factor. The factor is a percentage of the original principal that remains as a result of loan amortization. So for example, if you have a mortgage pool with a factor of .65, that means that 35% of the principal has paid down already, 65% or .65 remains. And so, if you have a new pool, the factor is going to be 1.00, because 100% of the principal is still there in the pool.
One of the things that you will see when you're talking with brokers, particularly about mortgage securities, is you will hear them refer to both the original face amount and the current face amount. The original face amount is talking about the amount of principal that was there at the time that the pool first started when it was at 100%. The current face amount is referring to the factor. And it's taking into account the reduction that's occurred in the principal, just through normal paydown activity. And so you might hear someone say, “1 million original face, the current face is 650,000.” Well, what that means is originally it was a million dollars, but because of principal pay downs, the factor as you know, it's taken it down to 650,000. So that's the factor and how we use that.
The next term I want to talk about is the weighted average coupon, or the WAC, W-A-C. A weighted average coupon is the average interest rate on the loans in the pool weighted by the size of each individual loan. So bigger loans have a bigger weighting in the pool. Not all loans in the mortgage pool have the exact same gross interest rate. If you were to go and look at a pool, the weighted average coupon might be 3%. But the actual coupon rates could vary anywhere from 2 5/8% to 3 ¼%. But when you weigh them based on their size and average them together, you come out with the WAC of 3%.
Now one of the things that I mentioned earlier was the difference between the weighted average coupon, the WAC, and the pool coupon. The pool coupon is going to be lower than the WAC. We talked before about the fact that servicing gets deducted, the guarantee fees get deducted. And so when you look at the pool coupon, it's going to be lower than the WAC.
The next term is the weighted average maturity, the WAM. This is the average final maturity on the loans in the pool, again, weighted based on the size of each individual loan. So that's what the WAM is.
Another term that you would want to be familiar with is the weighted average loan age, or the WALA, W-A-L-A. This is the average number of months that the loan has been paying weighted again by the individual loan sizes in the pool. So, if you were talking with a broker, and they said that they had a pool, and it was seasoned, and the WALA was 15 months, what that means is that this pool has been around and the average amount of time that the loans have been paying down has been 15 months. So looking at the WALA will give you an indication of how seasoned the pool is.
And then the last term that I want to cover is weighted average life. Now, unlike bonds, final maturity is not a good measurement for mortgage securities. If we're looking at a five-year agency bond, for example, we know what our principal cash flow is, it's going to happen at the end of year five. We can't say the same thing for a mortgage security. The definition of weighted average life is the average length of time that each dollar of unpaid principal on a mortgage-backed security remains outstanding. In other words, it's the average amount of time that it will take to receive your principal payments, both scheduled and prepayments, which we'll talk about a little bit in just a moment.
Calculating the weighted average life will tell you how many years it will take to receive roughly half of the amount of the outstanding principal. So, it's not a final maturity. It's the halfway point based on the amortization. The weighted average life is also used to determine where a mortgage-backed security lives on the yield curve. So for example, if you have a mortgage security with a three-year weighted average life, if you were to try and compare it to other bonds, you would want to look at the three-year part of the curve, that's where it's going to reside. Now, keep in mind that weighted average life is not a fixed number. It's going to fluctuate depending on the speed with which your principal cash flows come back to you. And that brings us to the concept of prepayments.
A prepayment is any unscheduled payment of principal on a mortgage security. Now, as you know, borrowers are going to make their monthly mortgage payments and those are scheduled payments. But then there are other circumstances where you're going to see your principal come back to you sooner than you had expected based on the scheduled amortization.
So why prepayments? Well, think about your own experiences. If you have ever refinanced a mortgage on your property, congratulations! You're a prepayment. If you ever moved, or you sold your house, and there was an outstanding mortgage, but you basically had to pay that off as you were moving. Again, you're a prepayment. If you are somebody who has made any extra principal payments on your mortgage, either adding a little bit to the monthly payment for principal purposes or if you were doing a biweekly payment, so there were some extra payments going to the bank. Again, you are a prepayment under those circumstances. Those are considered curtailments. But all of those situations - refi activity, moving or selling the property, extra principal payments - are all situations where the principal is coming back faster than the scheduled amortization. And that can affect the way that your mortgage securities are going to behave and how they're going to act within your portfolio.
And in the next episode, we're going to dive much deeper into measuring prepayment. We're going to talk about prepayment risk. We're also going to talk about extension risk, which is the other side of prepayment risk, and ways that you can manage and mitigate prepayment and extension risk as you try to manage your portfolio.
So, I hope that you found that helpful as an introduction to mortgage securities. If you have a question regarding anything that I covered today, please reach out. You can email me at chris@bondinvestmentmentor.com. I’d love to hear from you! Also, if you have any topic suggestions, as I said, I've been hearing a lot about mortgage securities and CMOs. So here we are! And thanks to those of you that have reached out with topic ideas. I really appreciate the input.
If you found this information helpful, I'd like to invite you to subscribe to the podcast. You can subscribe on any of the major platforms: Apple, Spotify, Google or you can use whatever podcast app you use. You should be able to find the podcast. If you do listen via Apple podcasts, would you consider please leaving a star rating or review? It helps others discover and learn more about the podcast.
If you're looking for more information about bond investing or portfolio management, please check out the website, BondInvestmentMentor.com. where you'll find articles, tips, and resources to help you on your journey in managing your institution's investment portfolio.
If you'd like to connect with me on social media, please reach out. You can find me on LinkedIn at Christopher Nelson CFA, or on Facebook at Bond investment Mentor. I would love to hear from you! I'd love to connect with you, it'd be great. I look forward to catching up with you soon! Thanks for stopping by. I look forward to seeing you next time. Have a good one!
[Music Out]