| |
| Dave Montano |
Montano is a managing director and head of mortgage-backed securities research at J.P. Morgan in New York. He's spent about two years at the firm and previously was at Credit Suisse First Boston.
How will a flatter yield curve affect the MBS market?
It depends on the pace and the extent of Federal Reserve tightening. Both factors are relevant. Mortgages have done really well. The Fed has indicated that the tightening speed will be measured and the mortgage market is relatively prepared for some tightening. The market has sold off a fair amount in anticipation and the risks are well balanced; the market has priced in a 25 basis point tightening. The Fed Funds rate is only at 1% now and the market has already discounted Fed tightening. The market is not prepared for a 50bps tightening and that is a serious possibility. If the Fed tightens by 25bps, the market will rally.
What is an ideal rate increase for the market?
I think the Fed should tighten by 50bps now rather than later. The market has already discounted a 25bps tightening and has sold off far enough. It is easier to tighten at the earlier stage than later when it can actually cause more damage. Tightening in stages and in small dozes creates uncertainty leading to high volatility. In 1994 when the Fed tightened by 25bps in the first stage and then 50bps and 75bps later, it caused chaos. That is when the damage occurred. So raising funding costs quickly to reasonable levels from historic lows and thereafter not raising at all or waiting for fresh data would be a more predictable course for the market. In my view, though the market is not expecting a 50bps raise, a 25bps raise will keep the uncertainty growing. It will not be clear by how much the Fed will tighten again.
Is the market hedged well? Do you see a repeat of 1994?
The MBS market is well-hedged and has priced in a 25bps tightening. The only issue is a possibility that it could go up by 50bps. There are a lot more speculators in the market than in 1994, with the involvement of hedge funds. The market anticipates what happened from historical data. That is why the market is so whippy. The hedge funds short the market and when they cover the market comes right back. The market is more sophisticated today than it was in 1994.
What do you think the market is ignoring or overlooking?
The three variable factors that influence the mortgage market are the Fed funding rate, home sales and the shape of the yield curve. The shape of the curve and Fed funding are related. The market does not appreciate the curve movements and its impact on valuations. The market is accustomed to looking at specific points on the curve like the five-year and 10-year. The market looks at value based on short-term carry--how much income is being generated versus funding. This makes sense when the Fed is easy. It is wrong when the Fed is tightening. The lack of ability to ignore the short-term carry and not learning to look at the fundamental value to the forward curve is leading to incorrect valuations in the market.
Can you describe the role of adjustable-rate mortgages in the market?
ARMs are very relevant today especially when rates back up and the curve remains relatively steep. Affordablity is a major driver in the market as originators are scrambling for market share, rates are rising and home prices are relatively high.
While the increased supply of ARMs issuance is a positive for the securitized fixed-rate market, it is atrocious for the ARMs market. The spreads relative to fixed-rate mortgages are widening. Fixed-rate mortgages are securitized by banks and sold. They are not retained by banks. The ARMs are not securitized. The banks have to retain them in loan form and not in securitized products as investments, or they have to find buyers of whole loans. It is a harder process and this is causing some pain. There could be increasing balance sheet problems.
Several banks, including HSBC and Barclays Capital, are setting up MBS businesses. Is now a good time to do so?
MBS is in some ways an inefficient market. There are not too many dealers involved in the market, even though it is a huge market. Any investment bank wanting to be a full-service shop has to have a mortgage operation at this point because of the size of the mortgage market. Banks that do not have it have to get into it by either buying a large U.S. bank or setting up their own shop. It is not so much to make it a profitable business out of it or a desire to make it profitable. That may not be the end-all objective. They have to provide a full service. The new entrants into the business may not focus on making revenue right now. It is a hard time to make money.