The markets continue to make corrections in all areas as the new administration prepares to take office, and there are only a short 10 days until the inauguration of Donald Trump. What the world, and the markets for that matter, will look like are still under debate. The 10yr Treasury and mortgage rates have certainly felt the impact, with the 10yr rising over 80bps since Election Day and now has settled around 2.38% today, up 55bps since November 7th.
What you may not have noticed is the volatility around the Fannie Mae(FNMA) and Ginnie Mae(GNMA) mortgage-backed securities (MBS) markets. Most conforming loans are pooled into Fannie MBS’s while FHA and VA loans are pooled into GNMA MBS’s. GNMA securities typically trade ½ point to ¾ point higher than FNMA’s due to the fact that their securities have an explicit US government guarantee among other things. With the uncertainty around the future of Fannie and Freddie, the price of their securities had dropped and the spread grew to over 2 points in mid-December. Since that time the spread has come back to roughly 1 point today. In simpler terms this means that conventional loan pricing has been very volatile relative to FHA/VA loans since Election Day with swings of over 1 point (25bps in rate) and increased the advantages FHA had for 97% LTV loans. Given the need to reform both Fannie and Freddie at some point I would expect more of that volatility to continue as news around reform makes its way to the headlines. Would you invest in a FNMA security that might lose its implied government guarantee? That’s the unlikely threat that lingers.
The other market nuance going through some shifts prior to inauguration is the shape of the yield (Treasury) curve. The most common method to describe the shape of the Treasury curve is the spread between the 2yr and 10yr. For most of 2016 that spread was approximately 100bps, meaning the 10yr is 100bps (1%) higher in yield than the 2yr Treasury. After Election Day that spread grew to 135bps in December and now is at 120bps. That spread change may not seem like much but think about it in these terms. 5yr ARMS are priced close to the 2yr Treasury and fixed rates are priced off of the 10yr Treasury. Which means the rates on ARMs are an additional 0.25% better in rate than fixed rates from just 60 days ago. The higher that spread, the steeper the yield curve and the greater incentive for borrowers to choose ARMs. This will be something to keep an eye on. Will sudden higher rates force borrowers into ARMs?
With the steepening yield curve and the FOMC raising short term rates, suddenly there is a lot of pressure on a bank’s asset liability manager. Banks for the past several years have fattened up the balance sheet with primarily fixed rate loans. These loans were originated at historic low rates and typically were only lasting 2-3 years (many would argue even less). Now with rising rates those loans could be on the books 10 years or more. Rising interest rates reduce the return on those fixed loans (remember the bank earns the fixed interest rate on the loan but pays higher rates on deposits when rates rise). This will put pressure on a bank’s earnings and eventually more profit will need to be priced into new originations. Some of the balance sheet advantages banks have held with near zero short term rates may dissipate and portfolio’s may not be the cash cow they have been. Would you rather own a 3% 30 year fixed mortgage that requires capital and there is potential for losses, or would you rather own a 30yr US Treasury with next to zero credit risk and minimal capital requirements at a 3% yield?