Slam Dunk Stimulus? Easier Said Than Done.

Battling arguments were noticeable in the mortgage market this week. One side is touting the benefits of a program where underwriting standards for conventional refinancing would be ignored going forward in an effort to allow otherwise unqualified borrowers to refinance and pocket substantial savings from a reduced interest rate. The counter argument points out the operational problems with such a program and the little effect it would have in the end.

I have spoken plenty about how MBS continues to tighten to Treasuries as the rate environment remains low. In addition to investors stretching out to find spread in new areas, traditional risks in MBS have lessened as a result of the fall in home values. We’re talking about prepayment risk here. In normal times money managers and banks would avoid paying 110 for MBS out of fear that prepayments unexpectedly spike and enough of your bond is called away from you at par that losses are realized. Home values are so depressed that a large amount of homeowners with 6% mortgages are unable to refi due to Loan to Value ratios over 80%, and in many cases over 100%. Without refi risk in the traditional sense, MBS runs out of control, circa right now, but as many here at Acropolis have said, today’s market is unique for a number of reasons.

Despite no chatter actually coming from policy makers in Washington, a couple reports from big players on Wall Street threw the market into a frenzy this week. Morgan Stanley’s Paper “Slam Dunk Stimulus” was one of those reports. Here are some highlights.

• They estimate little more than 40% (on a principal outstanding basis) of agency-backed mortgages have LTVs higher than 80%, plus another 10% that don’t qualify due to bad FICO score.
• Allowing that 50% to refinance amounts to $46 billion per year in interest savings.
• This gets past one of the home value dynamic that is holding back the household borrowing benefits of loose monetary policy.
• They argue it improves the credit quality of the agency’s guarantee book by lowering monthly payments.
• They do admit this would be terrible for bond holders, namely some holders of agency MBS who have bought high dollar paper. Negative convexity would come back with a vengeance and spreads would widen considerably.

The counter argument comes from Barclays. “Easier Said Than Done”

• They don’t deny that many homeowners are stuck in mortgages they would love to refi if they could. They point out that despite record low mortgage rates, homeowners now are refinancing at half the rate they were between 2000-2008.
• In addition to the obvious reasons, (LTVs and FICO scores), banks are holding back even solid-credit borrowers due to put-back risk. (Fannie and Freddie can return bad loans back to the bank they bought them from if they determine that they were underwritten incorrectly.)
• The problem comes about when the FHFA will have to get underwriters (i.e. big banks) to go along with the idea of refinancing anyone and everyone with a high rate mortgage. Most likely by getting rid of the “put-back” option, and increasing the fees to the banks.
• Barclays points out that relieving the put-back option and increasing fees could very well be seen as another big bank bailout, but it could not be done any other way in reality.
• Also, the new mortgages will have to be reissued in the bond market and denoted as different from what trades with a FNMA/FHLMC right now. The market will probably assign a considerable discount to the new product and much of the benefit could be lost.
• In the end, Barclays estimate is for $6 billion/year in savings, a mostly insignificant amount.

The dangers of having the Fed buy more paper are obvious. Deflationary themes have made a comeback these past couple months, and the latest economic data justifies it. This probably means QEII is unavoidable at this point, but the idealist in me is still holding out hope that policy makers will explore other options.

Again, investors are left to assess risks that are not able to be modeled. I know this is only idea stage stuff here, but new levels of government involvement is becoming more and more a part of everyday investing. If this becomes reality, which is pretty far off even still, bond investors stand to lose along with homeowners who have made responsible decisions and were able to reap the benefits of refinancing at much lower rates. However, bond holders who haven’t stretched out stand to benefit on a relative basis. A part of the mortgage market has been trading without a higher prepayment scenario as part of their risk analysis. Investors who have stayed away from that segment are in a safer position in that regard and will outperform if this policy becomes reality.

Have a great weekend.