Making Money Off Fannie Mae

Our investment methodology has us less than enthusiastic about investing in the equity markets, but we have been looking for a place to park cash. The markets got into this mess because of mortgage backed securities and I say dance with the one who brought you. Words like toxic, complex and tranche has everyone scared, but fear is just a perception. The reality is that some of these securities are as safe as government bonds.

Since the government takeover of Fannie Mae and Freddie Mac, the guarantee of their securities has changed from implicit to explicit. If a homeowner defaults on his or her mortgage, Fannie and Freddie pick up the tab. Before the government takeover the fear was that neither company had the cash to pay for the tab. This fear resulted in the spread of agency securities over treasury securities to be the highest in 5 years. 

The following charts show the current coupon for FNMA 30 year pass through securities.

Bloomberg FNMA MBS 30 Year Current Coupon

Source: Bloomberg

As the credit crisis deepened the coupon on Fannie Mae mortgages has actually gone up.  This is despite tighter lending standards and an explicit government guarantee.  Now look at what 10 year bond yields have done this year:

Ten Year Treasury Yield Index (TNX)

Source: Bloomberg

These two charts illustrate that FNMA mortgage rates are back at the year highs, while treasury rates are not. While these two rates are not directly comparable because of the differences in duration, they show the general direction of rates. 

If we look at securities of equal duration we also find that there is a discrepancy. Using the Lehman Brothers Aggregate Indices we can compare different investment choices with similar risk profiles and durations.

Sources: Lehman Brothers and iShares

Both the US Treasury 3-7 Year Index and the US MBS Index have similar duration, but very different yields. Typically, the difference would be accounted for by the risk premium, either the risk of homeowner default or Fannie Mae default. Since Fannie Mae guarantees the cash flow of the underlying mortgages the difference is therefore attributed to Fannie Mae default risk. 

However, now that the government is explicitly backing Fannie Mae, that risk is gone. Therefore, Fannie Mae MBS should trade at yields similar to 3-7 year Treasury securities. This is a great example of the tremendous dislocations that are occurring in the markets, and it also represents a great opportunity.

Included in the table is the duration and yield for the iShares Lehman MBS fund (MBB). This fund invests in Fannie Mae mortgage backed securities. The fund’s objective is to mimic the Lehman MBS Index and therefore has a duration that is similar to that index. That makes it a suitable proxy for an investment in mortgage backed securities.

A rational investor could buy this fund and collect over a 5% yield while waiting for rates to converge. The kicker is if rates do converge, the fund should see capital appreciation. If directional risk is undesirable, simply add a short position in the iShares Lehman 3-7 Treasury Fund (IEF).

Disclosure: I have a long position in MBB.

Comments

[Mortgage Re...:]

Thank you for the tips. This sounds like an opportunity worth looking into.

2008 Oct 22 07:58 AM