Bid Tape AOT Cash Considerations in a Deteriorating Market
As much of a boom as the past two years have been for the mortgage industry, 2022 has already seen widespread margin compression and decreased expectations for origination volume. Established mortgage companies have been through these market cycles before and have (hopefully) put fundamental policies, procedures, and marketing plans in place to cope with changing market conditions. The phrase “cash is king” is as important as ever, however, for lenders as a predictor of long-term enterprise viability.
On the loan sale execution side, one of MCT’s primary objectives is to take friction out of the secondary marketing function and achieve the true best execution for our customers. While trading efficiencies have increased over the last several years, looking mathematically at friction that still exists in selling agency loans on a mandatory basis, the biggest friction is the transaction cost that occurs when one pairs out of the hedge position, aka, the bid offer spread.
The bid offer spread, or friction cost that exists, comes when offloading (selling) a long position as a lender, rate locks, to the investor in the form of a mandatory commitment. The lender has the short position that needs to be paired off (bought back). Even in today’s very efficient market with electronic execution tools like TAM to help TBA execution, there is still up to a 3-basis point bid offer spread. With margins already very thin on the aggregator side, 3-basis points in an agency execution is a lot of execution to gain. Or lose.
The best way to take that friction cost out is by assigning that trade position to another party. Bid tape AOT (assignment of trade) execution combines the granularity of price available via bid tape with the cash benefits of assigning the trade, which have historically been mutually exclusive. MCT continues to innovate on the AOT side within BAM Marketplace, allowing our clients the ability to lock in that security spread commitment execution for the two parties, the seller and the buyer, prior to approval of that seller.
The AOT cash benefits that occur in a market rally (with rates dropping, security prices rising and margin calls) are well known, and have the ability to remove a truly existential threat to an independent mortgage banker. However, there is often more cash benefit realized in a market deterioration. That is because one can sell a loan today and hedge it with a security from an upcoming month that won’t actually settle until that security month. When the investor purchases the loan a week from now, there is a full month between taking that cash hit on selling an unprofitable loan and realizing the cash gain from the security. Utilizing the AOT, MCT’s clients are able to fast forward that pickup and get that in with the loan sale.
It is a common myth that if you’ve got a pair off on a trade and you assign the trade, the pair off disappears. That money is wrapped into the purchase price. For example, $2MM of Fannie 3.5s that have an original price of 101.375 need to be assigned, loan execution is at 101.875, and the current market is at 102.875. If there is a 100-basis point rally in this position and the lender short that position, the trade is 100-basis points, or $20,000, “out of the money.” When a trade is assigned to another party, it takes the loan value and drops it correspondingly in a linear fashion down to par, reducing loan execution accordingly. Bid tape AOT programs allow for the ability to not have to pair off the corresponding security, but rather assign that security to the investor and deliver the loans against that trade.
The process is not complicated, and utilizing bid tape AOT execution is a win-win for both investors and lenders, increasing competition by providing better execution for the lender without having to give up margins. If you are looking to receive the full price enhancement benefits of delivering via live bid, smooth out cash flows, reduce MTM exposure, and reduce trading costs, bid tape AOT is an excellent option to have in one’s execution arsenal. As part of our initiative to continuously innovate, MCT has recently released support and automation for bid tape AOT loan sale executions within our Bid Auction Manager. We are on a constant march to have a trade behind every aggregator commitment.
Federal Reserve MBS Tapering Impact on Prices
With inflation sitting at its highest level in four decades and the unemployment rate back down to just below 4%, the Federal Reserve made clear in its most recent minutes from January’s Federal Open Market Committee meeting that it is time to withdraw stimulus from the U.S. economy, an announcement that many analysts, economists, and traders view as overdue. The Federal Reserve has purchased nearly $3 trillion of mortgage-backed securities (MBS) since it resumed quantitative easing in March of 2020. This has certainly helped stabilize our economy through some rough patches, but enough is enough.
The Federal Reserve typically engages in quantitative easing to stimulate the economy out of necessity during an economic crisis, which was the argument for engaging in asset purchases over the last two years. At the start of the COVID-19 pandemic, the Federal Reserve’s purchases of MBS were intended to facilitate whole loan liquidity and help counter rapid changes to aggregator eligibility criteria and pricing. The thinking was that “greasing the wheels” of the residential lending sector was key to keeping the economy from crashing. Since then, the Federal Reserve has been prudent to withdraw support for the economy prematurely.
The influx of daily MBS purchases has caused the Fed’s balance sheet to increase from about $4 trillion pre-pandemic to $7.4 trillion at the end of 2020 to $8.9 trillion as of the time of this writing. This is not ideal: It is not the role of the Federal Reserve to keep such an extensive amount of MBS on its balance sheet. A more appropriate place for MBS is in the hands of private investors, mutual funds, and insurance companies, traditional owners. The true questions for the mortgage industry are, “What will happen to MBS prices, and thus rates for borrowers, as the Federal Reserve takes its foot off the throttle and exits the space? How will the demand for MBS be sustained after the Federal Reserve pulls back?”
One can draw the simple conclusion that the Federal Reserve buying almost 80% of available MBS supply has kept prices artificially inflated. As it buys less, we will see upward pressure on interest rates. The Federal Reserve started the process of tapering its MBS purchases at the tail end of 2021, going from purchasing roughly $30 billion a week to about $18 billion a week currently. We’ve already seen MBS prices drop and interest rates rise as a result. Even regular payups like those of the multi-issuer and major pools are trading lower, driving up the cost of the hedge for lenders and therefore impacting borrower’s rates.
The mortgage industry set a record last year with estimates of nearly $5 trillion in residential originations. That is a whole lot of MBS supply for the market to soak up, even with MBA predictions calling for it to return closer to $3 trillion this year (due to less refinance incentive, limited supply on the market, and many people returning to big cities for work where renting is the primary option). Additionally, a record low percentage of Americans say it’s a good time to buy. Ten years ago, in 2011, there were only $1.2 trillion of originations. In some senses, it is welcome news for the Federal Reserve that originations are expected to drop this year; that will help offset some of the MBS supply private money has to soak up.
Returning to the Minutes from the January Federal Open Market Committee’s meeting, they showed participants observing, “…in light of the current high level of the Federal Reserve’s securities holdings, a significant reduction in the size of the balance sheet would likely be appropriate… sometime later this year.” That is a marked departure from 2015, when the Federal Reserve waited two years to start tightening after raising rates. The Federal Reserve has a lot more MBS on its balance sheet now than after its previous periods of quantitative easing, meaning more influence over pricing, and returning the balance sheet to the pre-pandemic proportion of GDP (20%) would imply a balance sheet of $5 to $6 trillion in 2025. Selling MBS too rapidly would put pressure on the bond market, ultimately creating a more volatile climate.
Federal Open Market Committee participants generally noted at the January meeting that current economic and financial conditions will likely warrant a faster pace of balance sheet runoff than during the period of balance sheet reduction from 2017 to 2019. There is no specific timeline as of now, though the March Federal Open Market Committee meeting will provide more clarity on the matter. Expectations are for the committee to start by allowing up to $10 billion per month in maturing bonds to roll off the balance sheet, then ramping up the monthly limit to $70 billion and then $100 billion by the second half of 2023. Another strategy is to simply let all currently Federal Reserve-owned MBS to mature and not invest in anymore, letting its balance sheet slowly taper to an appropriate proportion.
Fortunately, the secondary mortgage market has seen some technological advancements that will help ease the pain of the largest buyer of MBS leaving the space. In the face of changing aggregator eligibility criteria and pricing, MCT continues to facilitate whole loan liquidity between clients through the BAM Marketplace™loan exchange. BAM Marketplace leverages the full power of the Bid Auction Manager (BAM) whole loan trading platform within MCTlive! for the purposes of finding alternative outlets and deals on whole loans. BAM Marketplace is included in the services MCT provides to hedge advisory clients with no additional fees or setup required. BAM Marketplace is also offered as a stand-alone platform to non-clients and other industry participants to provide support in turbulent times through improved liquidity and execution.
The Federal Reserve doesn’t have a magic wand when it comes to stoking Wall Street demand for MBS. Rather, it has the unenviable capacity to crash the housing market and the economy if it misreads the situation. Unlike last time the Federal Reserve scaled back its asset purchases, inflation is forcing tightening at the same time as the Federal Reserve wishes to raise the interest rates it has direct control over, primarily the overnight Fed Funds and the Discount rates. For their part, MBS prices obey simple supply and demand economics. Even with less originations expected this year, MBS prices will go down and rates will rise unless more demand comes from somewhere.
