Are we seeing the end of the current market cycle? Investors have been discussing this question, spurred by heightened market volatility and increased concerns about slowing growth globally.
Naturally, this has led investors to draw comparisons between today’s environment and the economic conditions that preceded the financial crisis of 2007-2008.
The U.S. residential mortgage market, a driving force behind that downturn, has changed significantly over the last decade in terms of both borrowers’ credit quality as well as composition of issuers.
The Housing Market Bubbles
In the early 2000s, with loosened lending standards it was relatively easy for the average American to obtain a mortgage. At the time, the size of the U.S. residential mortgage market was roughly $10 trillion. Almost half of that was pooled into agency mortgage-backed securities (MBS) and sold to investors.
Agency MBS are bonds supported by the U.S. government that are issued or insured by one of three agencies – the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac) or the Government National Mortgage Association (Ginnie Mae). Non-agency MBS, issued without government support, comprised another $2 trillion. The remaining mortgages were unsecuritized and held by large institutions and banks.
The Bubble Bursts
Before the housing bubble, non-agency MBS issuance was robust. However, it shrank considerably after the crisis and is very small today. Subprime mortgages and other risky debt dominated the non-agency market, which is why it all-but disappeared when those loan defaults multiplied.
For the average U.S. fixed-income investor that uses the industry standard Bloomberg Barclays U.S. Aggregate Index as a benchmark, it’s important to note that the index only includes agency MBS; non-agency MBS and unsecuritized loans are not included.
Today, agency MBS account for roughly two-thirds, or $6.5 trillion, of outstanding U.S. residential mortgages, which translates to a 28% weight in the Bloomberg Barclays U.S. Aggregate Index.
The market for agency MBS began in the 1970s following the creation of Fannie Mae, Freddie Mac and Ginnie Mae. These entities forged the way for the U.S. government to promote home ownership as the agencies in effect directed investor capital to lenders, which allowed them to originate large volumes of mortgages.
A quarter century later, in 2006, when housing prices started falling, borrowers defaulted on their mortgages and the agencies, Fannie Mae and Freddie Mac specifically, required a government bailout. Ginnie Mae, as a fully government-owned entity, already had the credit of the United States backing its securities.
On the other hand, Fannie Mae and Freddie Mac, originally government-subsidized private companies, were both put into government conservatorship after the housing bubble with future profits going to the U.S. Treasury.
With the government backing that agency mortgage-backed securities enjoy, the market is considered high quality and liquid. That said, the credit fundamentals of the underlying mortgages making up those pools are still important and have changed over the past decade.
Credit Fundamentals Change
Prior to 2013, lenders who originated mortgages securitized by the agencies were primarily banks. More recently, non-banks have become the majority supplier of mortgages that make up agency MBS. What’s important to know is that compared to banks, non-banks, on average, are more willing to offer loans to lower-quality borrowers. As the share of loans originated by non-banks in the agency MBS pools grows, the average credit metrics for the MBS securities also weakens.
Ginnie Mae’s explicit government backing and Fannie Mae and Freddie Mac’s conservatorship status may assuage some concern, but the shifting quality of underlying credit is still worth monitoring. In addition, the U.S. government is in the early stages of developing a plan to return Fannie Mae and Freddie Mac to the private market, which could have an impact on future supply and investors’ perception of the bonds’ safety.
Nevertheless, the agencies most likely will continue to have a dominant presence in the MBS market and, if supported, privatization would not happen overnight.
A factor that could also have a material impact on the U.S. residential mortgage market is interest rates. If the Fed continues to ease and rates move closer to zero, we could see more refinancing and millennials putting down roots.
How the U.S. residential mortgage market evolves in the coming years remains to be seen. However, given the market’s overall size and weight in core fixed-income portfolios, it will undoubtedly receive a considerable amount of attention as the government shares more details on its plans to recapitalize Fannie Mae and Freddie Mac.
For more information about this topic or if you have questions about your portfolio, contact an advisor at Fi3.