The Mortgage-Backed Securities Market Faces New Challenges

Mortgage rates in the United States have soared in 2022, helping to cool housing demand from home buyers. However, new risks are facing mortgage-backed securities (MBS) holders as well.

The vast majority of residential mortgages in the U.S. are securitized through the agency MBS market, which is the second-largest debt market in the U.S. behind U.S. Treasuries. The total MBS market rose to more than $12 trillion in 2021. Banks alone have added $1.3 trillion in MBS over the last five years.

Today the MBS market is facing a few serious headwinds, including regulatory changes requiring increased trading margin, a widening mortgage/treasury basis and a Federal Reserve unwinding its balance sheet.

According to BMO Capital Markets, total sales of fixed-rate mortgage bonds by government-baked entities like Freddie Mac and Fannie Mae will nearly halve in 2023 to around $300 billion from an estimated $550 billion in 2022. 

This will hurt the value of MBS, bundles of mortgage loans which value largely depends on the housing market's performance.

Banks typically sell MBS to investors in the secondary market, taking a slice or "discount" as a profit margin. Amid rising risks in the past year, they have cut their MBS exposure.

Specifically, they have slashed their holdings by roughly $100 billion to $2.8 trillion as of November 2022, according to Ethan Heisler, strategic advisor at bond rating agency KBRA.

As the Fed continues to raise interest rates , prices in the $8.7 trillion agency or government-backed MBS market could fall further, prompting financial institutions to trim their balance sheet to stem losses, analysts said. 

The market is grappling with historic uncertainty surrounding Fed rates, but also about the extent to which the Fed will continue to unwind its $2 trillion fixed-income balance sheet. Currently, $35 billion of MBS is scheduled to roll off the balance sheet each month.

"There is a lot of uncertainty about the Fed," said Heisler. "I started my career in 1981, when Chairman Volcker was in office, and rates were 20%. There was a lot of volatility surrounding Fed policy. We are back to those days.” 

Moreover, “No one really knows what will happen with inflation, how high rates will have to go up before the economy starts showing signs of strain,” he added.

John Coleman, senior vice president at fixed-income brokerage RJ O’Brien, said the Fed’s quantitative tightening (QT) is causing headaches for market participants as fears grow it will sell more MBS than initially thought, further depressing prices. 

“Investors are in a conundrum," said Coleman. "That is why you continue to see prices trending so low." 

Meanwhile, the QT program has triggered a liquidity crunch with analysts saying that while MBS are cheap, they will likely get cheaper, encouraging buyers to remain on the sidelines. 

Calls that the $44 trillion housing market will contract further are adding spice to an already heady cocktail. 

In a recent research note, Bright MLS said housing prices could fall another 10% next year as an affordability crisis offsets low inventory levels. Home sales could reach a nine-year low to 4.87 million, it added.

Still, Coleman doesn't expect housing price declines will mirror those of the late-2000s mortgage debacle when they plunged as much as 30%. 

“Most people that own homes have some amount of equity, with their home value greater than the loan to repay so they have a better buffer,” said Coleman. “This is unlike the 2008-2009 crisis where all of a sudden people were facing negative equity.”