Resist the Temptation of Mortgage-Backed Spreads

Although agency mortgage-backed securities (MBS) have been beaten up the last couple days, avoid the temptation to jump in. Agency MBS spreads are not as attractive as they seem, and the technicals for MBS are horrible.

This has nothing to do with the financial condition of Fannie Mae (FNM - commentary - Cramer's Take) or Freddie Mac (FRE - commentary - Cramer's Take). We'll have to see how the government bailout progresses. Perhaps just the act of allowing the GSEs access to the discount window will be enough to ensure liquidity. But by all indications, protecting the mortgage-securitization market (i.e., keeping mortgage borrowing rates low) is a primary goal of any government action. It isn't credit quality which is behind this underweight call. Rather, it's plain, old-fashioned market conditions.

MBS analysis is more complex than for other investment-grade bonds, in that the yield on the security is highly depended on the pace of principal repayments. These payments primarily come from two sources: refinancings and housing turnover.

Historically, refinancings were the primary driver of changes in mortgage-payment speeds. Anytime interest rates would fall, borrowers would rush to refinance, and thus pay off their old mortgage. Housing turnover was more consistent, as people tended to move from house to house based on life circumstances, as opposed to macroeconomic events.

But times are anything but typical. Various conditions are coming together which will keep homeowners in their current residence far longer than historic norms. There is a large number of homeowners currently underwater on their mortgage, and an even larger number with less than 20% equity.

Given that getting a mortgage with less than a 20% down payment is difficult and very expensive right now, homeowners who currently have less than 20% equity would have to come up with a lot of cash in order to move to another home.

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At the time of publication, Graff had no positions in the stocks mentioned, although positions may change at any time.

Tom Graff is a Managing Director of Cavanaugh Capital Management, a registered investment advisor in Baltimore Maryland. The opinions expressed here are Graff's own and in no way are the statements of Cavanaugh Capital Management, and may or may not reflect the strategies being pursued for clients of Cavanaugh Capital Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Graff appreciates your feedback; click here to send him an email.