By Eric Leininger, CME Group
At a Glance:
• Mortgage-backed securities issuance has dropped to historic lows as borrowing rates have increased
• New TBA futures aimed at mitigating MBS market risk are seeing increased trading volume
In an environment of rising interest rates, one of the first places the effects are seen is in the housing market. Demand from homebuyers is falling, and for banks a mortgage business that was thriving in 2021 has slowed significantly. Mortgage industry veteran Paul Van Valkenburg explains what this means for mortgage-backed securities – the second largest U.S. fixed income market after treasuries – which have seen issuances drop to historic lows.
“Issuance of mortgages is low because of higher rates. But what I anticipate – and what is already happening – is that originators will utilize this excess capacity to move into originating lower credit mortgages – non-qualified – which will predominantly be put on their balance sheet,” he said in an interview with Eric Leininger, CME Group head of Financial Research and Product Development.
Van Valkenburg co-founded mortgage asset analytical software provider Mortgage Industry Advisory Corporation (MIAC) in 1989 with Robert Husted. In the interview with Leininger, Van Valkenburg discussed the challenges facing MBS market participants and new tools available to help them mitigate risk.
In October 2022, CME Group introduced new 30-year UMBS TBA futures to help market participants manage MBS exposure and lower their margin requirements. These futures represent 30-year residential mortgages pooled into UMBS products backed by Fannie Mae and Freddie Mac. Trading volume surged in May, with more than 350 contracts traded daily and an average notional value of approximately $35 million – a sixfold increase on the previous month. The volume mix by coupon has shifted in favor of 4.5% and 5% futures in recent months.
Following is Van Valkenberg’s discussion with Leininger. It has been edited for length. Listen to the full conversation on CME Group’s OpenMarkets.
A recent report from the Mortgage Bankers Association stated that U.S. banks lost money on mortgages that originated in 2022. In the aftermath of the banking crisis, what are some of the key risks to the MBS market?
I would describe the risks as interest rate risk and pre-payment risk. However, there is another major risk to the mortgage market, which is counterparty risk. This is a problem that exists particularly in over-the-counter markets where all relationships are bilateral.
Housing is often thought of as a key economic indicator. What has the situation around bank losses and the mortgage business – where higher interest rates have reduced demand – shown us about the role the mortgage plays in the wider economy?
The U.S. mortgage market is the gold standard for the world. More than two-thirds (70%) of GDP is consumer purchasing – their most significant asset is their real estate, and their most significant liability is their mortgage.
So the mortgage market is central to a consumer’s economic health, and the U.S. has created this mortgage-backed securities market to bring more capital into the housing market. Because it has this mechanism to reach the investor to enable them to access this risk through the TBA and MBS markets, you have a lot more institutional capital coming into these markets, and there are tools for banks to manage their gap risk to lay it off to other parties.
Lending conditions are already tighter. How do these risks affect small and medium-sized banks?
SME (Small and Medium Enterprise) banks in the mortgage business will execute the strategy of securitizing and retaining the servicing. They want the consumer relationship and can manage their gap more effectively. What we saw was massive issuance in 2020 and 2021, so the capacity in the origination side of these companies is now underutilized.
Many of these banks will decide to put weaker credit mortgages onto their own portfolios, so we will see an acceleration in the non-qualified mortgage originations that will go onto bank balance sheets. Higher balance mortgages will stay on bank balance sheets.
With MBS issuance falling to a 23-year low, what does that mean for people trying to secure a mortgage?
Issuance of mortgages is low because of higher rates. But what I anticipate (and what is already happening) is that originators will utilize this excess capacity to move into originating lower credit mortgages – non-qualified – which will predominantly be put on their balance sheet.
There are mechanisms to securitize and sell these assets, but these are not as fluid as they were in the past due to risk retention rules designed to protect the solvency of these markets.
In the private label securities market, the thinly-capitalized originator has been eliminated because of this concern about counterparty risk, and the risk retention rule ensures the issuer retains at least 5% of the equity in a deal. It is an option but is a stronger barrier to entry.
These factors have created the conditions for TBA futures. Is having access to a variety of risk management tools vital in the current environment?
An exchange traded futures contract has had long standing appeal but to figure out the nuts and bolts of making it a success has been a major challenge, so congrats to you guys for getting it done. That it permits deliverability is a big plus. It can service mortgage banking constituents who can utilize it as if it was an over-the-counter futures contract.
So when it has institutional support across different sectors, it has the capability to service a broad spectrum of the market – which means when there is upheaval, there are going to be people on the other side who can help continue the liquidity in the market.
Recessions are a natural part of an economy’s cyclical nature. Generally, when you have a recession, you have a systemic decline in rates to combat lower demand and stimulate consumer spending. But if you have an increase in unemployment, you are also going to see credit events happening where there are more delinquencies and defaults.
With FINRA 4210 – which will collect margin on TBAs to help manage potential risks – scheduled to go live in October, what do you see coming down the line?
This comes back to counterparty risk. Let’s first look at the current over-the-counter market. There are layers of risk management where you have the highly liquid inter dealer market, traded through the screens, where all the liquidity and the capital is.
The next layer out is the regional dealer or broker, but they are not really putting capital up. Their role is to address the counterparty risk by taking the credit risk of the counterparty risk of the mortgage originators who have less capital.
So this counterparty risk is outstanding, and if we look at what happens when markets are under stress, such as in the sub-prime or global financial crisis, as you move down the food chain, parties are left exposed.
The regulators recognized the disruption this causes, and they have wanted to bring capital and margin standards to this over-the-counter TBA market. That was why FINRA proposed its 4210 rule for margin requirements in 2016, but there has been reluctance to implement the rule because market participants feel it is too disruptive.
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