If you don't know much about mortgage-backed securities, it's probably time you learned something.
While you might not own any of these securities, the activity this year in the MBS market could have some negative ramifications for the bonds and stocks you do own.
To understand how you could be affected, you first need to know what a mortgage-backed security is and how it is impacted by rising interest rates. The most commonly sold mortgage-backed securities are issued by
( FRE). These agencies buy mortgages from lenders and originators, bundle them together and sell pieces to the public.
An investor who buys one of these securities is essentially lending money to many different homeowners. The homeowners pay back the interest on the loan and part of the principal each month. In contrast, when investors buy a Treasury they receive interest every six months and don't get back the principal until maturity.
When interest rates fall, prepayments speed up, as people rush to refinance their mortgages. What this means is that MBS investors get back more of the principal -- or all of it -- earlier than expected. They then have to reinvest this money at lower interest rates.
is lowering interest rates, yields on Treasury bonds tend to decline while their prices goes up. But mortgage-backed securities tend to perform less well than bonds of similar maturities because of this so-called prepayment risk.
A rising rate environment also can have negative consequences. The resulting slowdown in prepayments means investors have to hold on to the securities longer than they expected, and the interest they're getting is now lower than what is currently available. In such a scenario, the price of mortgage-backed securities tends to fall more sharply than that of other bonds.
Indeed, these securities were punished in early May on fears the Federal Reserve would raise rates faster than expected. They've since staged a recovery, however.
So why does all this affect retail investors who probably don't own any mortgage-backed securities?
For one thing, the institutions that own these securities tend to hedge their positions with Treasuries. When rates are falling, institutions might buy Treasuries as a hedge against the prepayment risk on the mortgage-backed securities. When rates are going up, they often unwind these hedges, which can exacerbate selling in government bonds. Since the mortgage bond market is so huge -- it grew to $5.3 trillion in 2003 -- the hedges that traders put on can also be extremely large.
Karine Mercado, mortgage analyst at RBS Greenwich Capital, said Treasuries could slump further this year, as rates rise and mortgage-related selling intensifies. "Mortgage accounts are going to have to sell mortgages ... or sell more Treasuries," she said.
Meanwhile, a host of financial institutions own mortgage-backed securities in their investment portfolios -- large domestic banks held $503.8 billion of these securities as of May 5. This was down slightly from a month earlier, but up more than $100 billion from October 2003, according to Fed statistics.
Banks own mortgage-backed securities to offset the money they pay out to depositors in interest and to fund borrowing from the Federal Reserve and other banks.
Richard Bove, an analyst at Hoefer & Arnett, said he is concerned about thrifts, community banks and some of the larger banks, specifically
Harbor Florida Bancshares
, which he said are all heavily exposed to the MBS market.
"You've got a duration risk building in the banking industry," he said. "If you've got a mortgage which is yielding 5.75% or 6%, you're not going to sell your house for 10 years because as mortgage rates go up to 7%, 8%, 9%, you're not about to give up that mortgage."
Hoefer said that as mortgage-backed securities decline in value, a number of banks will have to take big writedowns or will see their earnings reduced. "If you're talking about a thrift, which has got roughly 55% of its assets in mortgages of one type or another, earnings could drop 10%, 15% or 20%, though that will take years to happen."
During periods of rising interest rates, thrifts typically sell at a discount to book value because investors recognize that the value of mortgage-backed securities is overstated on the balance sheet, Hoefer said, adding that he expects thrifts to fall 30% over the next 12 months. "You're definitely going to see the impact grab hold and negatively impact the value of these stocks," he said.
Jim Ackor, an analyst at RBC Capital Markets, said the impact on banks is often more optical than fundamental. Many banks hold bonds and mortgage-backed securities in their portfolios without marking them to market. In other words, they don't have to change their balance sheet to reflect the drop in the value of the bonds or mortgage-backed securities.
In 1999, Ackor said, rising interest rates slashed the value of Astoria Financial's bonds, but the company didn't sell a single security. "They basically said, 'OK, the bond portfolio is under water by x amount, the securities continue to produce good interest income for us and we don't have to realize these losses.' They held on and rode out the interest rate cycle," he said.
Of course, that doesn't mean investors will be kind to companies in this position. "Just look at
New York Community Bancorp
( NYB)," Ackor said, noting that the stock has fallen 34% since the end of March on concerns that the firm's bond portfolio is underwater by as much as $450 million on a pretax basis.
While the mortgage-backed securities market is dominated by institutional players and can often seem obscure or irrelevant to retail investors, its impact on Treasuries and on bank stocks can be far-reaching, and fluctuations in this market are definitely worth watching as the period of ultra-low interest rates comes to an end.