Reduce liability for losses on commercial accounts by adhering to four requirements.
Watching the Cash Register
Time has passed to near mid-year, and interest rates continue to move within a surprisingly low trading range that has extended in time frame far beyond what almost every legitimate market forecaster and observer foresaw. Many banks invest in and hold mortgage-backed securities in their bond portfolios.
With rates at generational lows, the vast majority of MBS holdings are owned at premiums, often substantial premiums. As hopefully every mortgage investor knows, MBS with book values at premiums set the stage for disappointment if the wrong things occur. Significant savings gained in refinancing higher-cost mortgages have driven prepayments beyond levels anticipated. Depending on the size of the premium and the faster level of prepayments, the holding period yield can be reduced if principal comes back sooner than expected. If so, the MBS you own at a premium, which likely are valued at a premium price, are paid back at par, resulting in a loss of the profit. The current (incredible) rate environment alone explains significant prepayment increases. Additionally, the new and improved Home Affordability Refinance Program, which allows homeowners with Fannie Mae and Freddie Mac mortgages issued before May 2009 to refinance at current rates, regardless of the value of their homes, is another dynamic that increases speed of prepayments. Therefore, it is important to monitor your monthly portfolio reports that detail and analyze your MBS holdings, enabling you to react in a timely manner to adverse developments that affect specific bonds.
Higher Coupon Issues
If you own MBS with a final maturity of approximately 70 months and shorter, with coupons of 4 percent and higher, be aware that dealers are paying extraordinary prices for these issues. The bid levels received often generate “give up” yields that are negative, meaning in bond swap terminology, a reinvestment in cash at a yield of zero will still generate a profit for the overall transaction. The rationale for these aggressive bid levels is that shorter WAM MBS with the aforementioned metrics are aggregated into new mega or giant pools, which are marketed with particular attributes and characteristics. There is healthy demand for these older, higher-coupon pools among the dealer community. You would likely generate outsized profits on the liquidation of these items, which would contribute to overall portfolio performance.
As discussed, prepayments have generally increased with continued low mortgage rates. Consequently, the block size of many MBS held may have quickly become smaller. As always, it only makes sense to monitor the current face value of each issue to ensure that they are sold before the size becomes so small that the bid side is incrementally penalized. A long-held benchmark for odd lot designation is 100,000 current face and below. While subjective, it is indicative of the general size where an extra “hit” is levied. Many safekeeping agents charge a fee that can become burdensome when only small amounts of offsetting interest earnings from the bond are realized. This situation can exist for more than a few years to the final maturity. As a facet of holding MBS in a portfolio, be diligent in keeping your blocks from becoming too small.
The longer we remain at these extreme lows in interest rates, logic suggests that more pressure will mount for households to minimize expenses by whatever means available to them. This will include their mortgage expenses, as consistently higher monthly refinancing numbers testify. Therefore, concerning prepayments, history may not provide as accurate a projection for various structures going forward as in the past. More now than at anytime in recent memory, commit time to consistently analyze the MBS holdings in your portfolio. Do this monthly as you receive your analysis of the holdings based on the most recent paydown information. As peer group comparisons recently covered in this column relate, MBS remain a stalwart of high-performing bank portfolios and on a relative value basis continue to be attractive. The situation is that they now require more management than in the past. After all, they are still loans, just in securitized form.
Larry Russell is senior vice president in the capital markets group at Country Club Bank, Kansas City.
Copyright (c) June 2012 by BankNews Media