by Kevin Kelly
The credit dislocations experienced across investment grade bonds, high yield bonds, and preferreds have also dramatically impacted the mortgage market. The credit moves in the mortgage market been relatively extreme with the spread on 30-year mortgages (Fannie Mae) versus Treasuries nearly doubling from a 0.95% credit spread (on 2/19) to 1.80% on 3/19. This is a truly remarkable dislocation for a typically stable market. This was driven by two major factors, first the massive surge of selling that occurred across fixed income markets in the past two months combined with these securities typically being purchased with substantial leverage. While agency mortgage spreads as of Friday (3/27) have fully reversed to pre 2/19/20 levels, we thought it was worthwhile to explain what happened.
The selling was exacerbated by forced selling due to liquidations and margin calls. If you acquire an asset with leverage, the provider of such financing demands a certain amount of cash/equity to ensure they are not taking the risk that the value of the assets declines below the amount they are owed (amount you financed). Therefore, if the prices of your assets, in this case mortgages, declines substantially, the financier of your purchase will demand you put up more capital/cash/equity. Investors in this space, including mortgage REITs, often use short-term financing, mostly repos, which must be renewed on a regular basis (sometimes averaging less than 30 days). This is very different than a Company that issues a 10-year bond, which the Company only has to refinance at maturity. Also, with bonds there is generally no concept of a margin call. If the purchaser of these mortgages, does not want to put up more cash/collateral or simply does not have more cash/collateral to meet margin calls, this can often cause forced selling. Significant margins calls were potentially trigged on March 19th when mortgage spreads over Treasuries peaked. Also, over the weekend of March 21-22, a very large mortgage investor, Annaly, tried to sell as much as $400 million in mortgages. The Fed saw these and other developments and announced major intervention to buy agency mortgage-backed securities ‘in the amounts needed to support smooth market functioning’ rather than previous $200bn limit. the morning of March 23. Over the next few days, a few, relatively smaller mortgage REITs, put out press releases that they did not have sufficient capital/collateral to meet margin calls. This all led to some investors in the mortgage market getting very worried about what Company might next have a margin issue.
Within a few days of its announcement and entry into the market, the Fed quickly provided a floor to mortgage bond prices. Additionally, on the financing side, on March 16th the Fed said it would continue to conduct term and overnight repurchase (repo) operations to ensure the smooth functioning of short-term U.S. dollar funding markets. As a result, repo costs have been declining and the market seems to be more rational and functional now.
These two major actions have caused many of the stocks and preferreds of mortgage companies to bounce back substantially from Tuesday’s close (3/24). For example, three of the names that highlighted margin call issues, are up more than 75% since Tuesday’s close. Some of the mortgage REITs have suspended their dividends to preserve capital, but the market has generally reacted positively to this as prudent management is currently much more important than one lost dividend payment. Regarding mortgage REIT preferreds, most of the ones we purchase are cumulative, so investors will be entitled to their dividend in the future before any common stock dividends can be paid. Given they are REITs, management teams will resume dividends once they are confident their liquidity position is strong.
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