NEW YORK The $5 trillion guaranteed mortgage-backed securities market has long been a technician's dream, with Wall Street shelling out millions of dollars on models that predict refinancings and interest rate trends.
But today, the biggest variable -- government intervention -- is a wildcard that cannot be captured by algorithms and is a curveball to the mutual funds, pension managers and other institutional investors who are funding U.S. homeowners via purchases of MBS.
Investors who buy securities issued by Fannie Mae, Freddie Mac and Ginnie Mae have been riled since July by fears that the government would move to boost refinancings. When a loan is refinanced, it creates a "prepayment" of principal to investors, which in today's market can create a steep loss.
"It's hard to trade on the probability the government is going to do something," said Kevin Jackson, a trader at Wells Fargo Securities in Charlotte, North Carolina, who as a former Fannie Mae manager has found himself increasingly interpreting government chatter for customers. "Prepayment models have been pretty useless."
The frustration has lingered even as analysts and Shaun Donovan, the U.S.' top housing official, have tried to cool speculation on policy changes. For more, see: [nN01136270]
Some of the biggest influences on the MBS market in the past two years have come from the federal government as it has tried to revive housing. One example is the loan modification program for troubled borrowers.
Weaker-than-expected economic reports last month may provide incentive for the Obama administration to take further steps to bolster housing ahead of the November elections, analysts said.
Investors cannot shake the idea that the government could again inject itself into the market because lenders are limiting the economic benefits of record low interest rates. Bank mortgage rates have not kept pace with the drop in other interest rates, and many lenders have narrowed the field of who qualifies for a loan.
"Underwater" borrowers, whose homes are worth less than what they owe on them, are also less likely to take advantage of lower rates, as they may have to write a check to cover lost equity.
"Policy risk and initiatives by the government are more likely to drive the secondary mortgage market than at virtually any point that I can remember in the last several years," said Ajay Rajadhyaksha, head of U.S. fixed-income and securitized debt strategy at Barclays Capital in New York.
Economists pondering slowing U.S. growth stirred the controversy more than a month ago. At Morgan Stanley, they suggested a "slam dunk stimulus" could be achieved if the government ignored credit checks and made a sweeping qualification of loans it already guarantees through agencies or Fannie Mae and Freddie Mac.
Investors are edgy as prices for most MBS are at levels that will sustain a loss based on refinancings, especially those created when 30-year mortgage rates were substantially higher than today's 4.5 percent. Investors betting that tight credit would keep refinancing slow on all MBS have been burned as risks of a U.S. policy shift have led others to sell.
MBS in August returned just 0.16 percent, severely lagging the 2 percent return for U.S. government and corporate debt and raising doubts about future returns, said Jim Vogel, a strategist at FTN Financial in Memphis, Tennessee.
MBS paying 6.5 percent interest flirted with $110 per $100 face value in late July before sliding to $108 by mid-August. A prepayment returns face value to investors.
"If you were to rely on a model, it would tell you to buy every (high interest rate) bond out there," said Mitch Flack, co-head of TCW's MBS unit in Los Angeles. TCW manages $109 billion.
Flack and other MBS investors believe "premium" MBS may drop further even without a big policy shift. Small changes within existing programs could have some impact, they said.
What's more, refinancings are also on the rise because interest rates have hit record lows week after week.
"The mortgage market is on the expensive side right now but it was crazy (costly) a month ago," said Scott Simon, who oversees MBS and ABS at Newport Beach, California-based Pacific Investment Management Co, which manages more than $1 trillion.
Pimco doubts any big policy shift is coming but thinks the government should make refinancing easier for borrowers locked out due to tighter credit standards such as higher credit scores, Simon said.
Some investors expect changes to the U.S. Home Affordable Refinancing Program, which has been largely ineffective. In addition, Fannie Mae and Freddie Mac could ease "representations and warranties" rules that lenders have interpreted so tightly that they lock out even credit-worthy borrowers, they say.
"They will look to make tweaks, but it won't result in a mass, government-induced refi wave," said TCW's Flack, who likes low loan-balance MBS that should see fewer refinancings.
Scott Buchta, head of investment strategy at Braver Stern Securities, says competition from smaller lenders is bringing rates down further. Like Flack and Simon, he sees a gradual, but not sudden, increase in refinancings.
In the meantime, Wall Street and investors are shifting views more frequently amid the confusion in U.S. policy. They have been susceptible to false alarms, including mistakenly viewing a "streamlined" existing Freddie Mac refinancing program as new.
"There are little rumors every day," said Buchta. "The market is jumpy because it was priced for perfection."
(Editing by Dan Grebler)