Mortgage-Backeds Offer Returns for the Vigilant

The agency-backed mortgage sure is tempting. Fannie Mae (FNM - commentary - Cramer's Take) 30-year 6% mortgage-backed securities are currently yielding 4.40% with just a two-year average life, according to Bloomberg figures. That looks pretty good compared with two-year Treasuries at around 0.80% and two-year Fannie Mae bullet debt at around 1.75%. Now that Fannie Mae and Freddie Mac (FRE - commentary - Cramer's Take) are owned by the government, one should view these credits as all the same. Why not take that extra yield?

But beware, there is likely to be a massive difference in MBS performance over the next year, as the government works hard to push mortgage borrowing rates lower. When a borrower repays his or her mortgage in part or in full, that repayment is passed through to the investor at $100. With almost all agency-backed MBS priced at $102 or above, investors will be taking a loss on every loan refinanced. For that reason, gauging the potential refinancability of your mortgage-backed security as well as predicting the direction of government policy will be the key. This is especially true of those holding agency collateralized mortgage obligations, which remain a popular product among individual and bank investors.

First question is, how low can mortgage rates go? According to Bankrate.com, the national average mortgage rate is now 5.57%, with government-sponsored-enterprise-conforming mortgages probably available in the 5.25% area this week, according to forward commitment rates. Rates could easily fall much further. The long-term average spread between the 10-year Treasury and mortgage rates is 152 basis points; the current spread is 300 basis points. Given that the Fed has pledged to buy $500 billion in agency mortgage-backed securities in 2009 (equal to half of 2008's total issuance), there is every reason to believe the spread between Treasury and mortgage borrowing rates will fall, at least for government-sponsored-enterprise-conforming borrowers.

Currently about 80% of the fixed-rate agency MBS universe has a rate of 6% or above. Under normal circumstances, we'd expect most of those borrowers to refinance. However, conventional wisdom says the combination of declining borrower equity and strict lending standards is likely to mute refinancings.

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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.