Resist the Temptation of Mortgage-Backed Spreads

So the housing turnover element of mortgage principal payments is set to plummet. In addition, the same factors will prevent many refinancings. A borrower underwater on his current mortgage will not be able to refinance his loan just because rates fall 50 basis points (bps).

This means that the average life of a mortgage is longer than is currently being assumed.

For example, a Fannie Mae 30-year 6% mortgage security currently has a nominal yield of 6.19% and an average life of five years. The average life is the median of a Bloomberg survey on prepayment estimates. That calculates to a nominal yield spread of 271bps.

Note that a 6% mortgage security is typically made up of borrowers with a 6.5% mortgage. Currently, mortgage borrowing rates are 6.26%, according to Freddie Mac. Under normal conditions, one would assume that a 6.5% borrower is relatively close to a refinancing opportunity. Hence, Wall Street prepayment models are assuming that this mortgage will pay principal slightly faster than this time last year.

More likely is that mortgages will prepay at historically slow rates. Cutting Wall Street's estimated prepayments in half, the mortgage's average life goes from five years to nine years. Because the yield curve is so steep, that results in the yield spread falling to 219bps. If you cut Wall Street's estimate by a third, the spread falls to 202bps.

As investors come to terms with the extending average lives, prices are likely to fall rather than yield spreads contract. Holding the 271bps yield spread constant, but extending the average life to nine years, causes the price to drop by over 3%.

Technicals for MBS remain ugly as well. Regional banks and credit unions were classically large buyers of agency MBS. But given the capital situation at banks, we are far more likely to see banks as net sellers of MBS over the next year.

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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.