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The Securities Industry and Financial Markets Association (SIFMA) today testified before the U.S. House Committee on Financial Services. Appearing on behalf of SIFMA, Thomas Hamilton, vice chairman of SIFMA’s MBS and Securitized Products Division Executive Committee and managing director at Barclay’ Capital, addressed the agency mortgage-backed securities (MBS) market, specifically the to-be-announced (TBA) market. During testimony, Hamilton outlined the importance of the market for MBS issued by the agencies in providing financing to the majority of mortgage borrowers in the US. He also discussed the reasons why SIFMA members voted to exclude jumbo loans from TBA trading. Ultimately, the inclusion of jumbo loans in TBA-eligible pools would have harmed borrowers of lower balance, previously “conforming” mortgages.
“The TBA market depends on perceptions of homogeneity – and the introduction of jumbo loans, which have significantly different prepayment characteristics, in any amount into TBA-eligible pools would have reduced the perceived homogeneity of the market,” said Hamilton. “Given that the TBA market is so essential especially in this time of stress, market participants are very hesitant to change the rules in a manner that they believe is likely to have negative consequences for liquidity and thus for the much larger class of conforming borrowers.”
Hamilton added, “SIFMA believes that the correct decision was reached regarding the TBA eligibility of pools containing jumbo mortgages. The decision strikes the correct balance between providing increased liquidity and rate relief to jumbo borrowers, while preserving the liquidity of the TBA market that provides lower rates to conforming borrowers.”
The potential negative effects of including jumbo loans in TBA-eligible pools include:
- Disruption of Lower-Balance Mortgage Market – The temporary nature of the conforming loan limit increase (expires December 31, 2008) coupled with the time required for both the GSEs and lenders to adapt their systems and lending operations to the new limits, would cause significant disruption in the TBA market for a program with a very short lifespan.
- Changes to Homogeneous Nature of Collateral will Lead to Uncertainty – The TBA market is the largest, the most liquid and currently the only active secondary mortgage market. The liquidity in the TBA market is attributed to the shared basic characteristics of the underlying loans. Introducing loans with significantly higher balances and different performance characteristics into the TBA market would change the fundamental homogeneity of the market, thereby impairing liquidity and negatively affecting the rates of loans with lower balances.
For most home mortgages, borrowers are able to prepay their mortgage loans at any time without penalty, either by refinancing at a lower interest rate, selling a home, or making an accelerated loan payment. As a result, MBS investors face the risk they will experience the return of principal earlier than anticipated and be left to reinvest at lower yields. Higher balance loans tend to have a greater potential for loan prepayments when the interest rates drop (related to a concept called “convexity”). If these higher balance loans were included in the TBA market, investors would generally lower the prices they are willing to pay for TBA trades to account for this additional prepayment risk.
- Increased Rates for Lower-Balance Loans – As bond prices drop, yields increase. If investors lower the prices they are willing to pay for TBA trades, the yields on the underlying bonds will increase. This increase would be passed onto borrowers. While there would be a decrease in the mortgage rates for jumbo borrowers if the loans were included in TBA-eligible pools, this would come as a result of higher rates for lower-balance borrowers.
