Consolidation to Crank Up CPRs?

 |  Includes: DX, FMCC, FNMA, HTS, NLY
by: Patrick Harden

I ran across a very interesting article from FT's Tracy Galloway that commented on the potential ramp in agency buybacks once Freddie (FRE) and Fannie (FNM) adopt FAS 166/167. Essentially, the consolidation of formerly off-balance sheet mortgage pools would eliminate the capital disincentive for GSEs to repurchase delinquent mortgages within their pools. An increase in repurchases by the GSEs could materially increase the constant prepayment rate ("CPR") for agency-backed mortgage securities.

The effect of an increase in CPRs on agency-backed MBS is summarized quite well in Hatteras Financial's 2008 10-K:

We may purchase agency securities that have a higher interest rate than the market interest rate at the time of purchase. In exchange for this higher interest rate, we would be required to pay a premium over the face amount of the security to acquire the security. In accordance with accounting rules, we would amortize this premium over the anticipated term of the mortgage security. If principal distributions are received faster than anticipated, we would be required to expense the premium faster. We may not be able to reinvest the principal distributions received on agency securities in similar new agency securities and, to the extent that we can do so, the effective interest rates on the new agency securities will likely be lower than the yields on the mortgages that were prepaid.

In other words, the folks that paid a premium to acquire fixed-rate and hybrid MBS at above market rates would have to expense that premium much faster than expected. The reverse, of course, is true for the discount on below market debt:

We also may acquire agency securities at a discount. If the actual prepayment rates on a discount mortgage security are slower than anticipated at the time of purchase, we would be required to recognize the discount as income more slowly than anticipated. This would adversely affect our profitability. Slower than expected prepayments also may adversely affect the market value of a discount mortgage security.

Were the GSE buyout scenario to occur, it would likely harm the profitability of groups like Annaly Capital (NYSE:NLY), Hatteras Financial (NYSE:HTS), and Dynex Capital (NYSE:DX). Typically GSE debt is sold at a premium, so few companies are likely to have material amounts of MBS with discounts to accrete to income.

The question of agency buybacks received some mention on several third-quarter conference calls. For the most part, the agency mREITs denied a material impact from potential GSE buyouts. Nonetheless, depending on when the Fed decides to raise interest rates, the GSE buyout question could be the second blow in a 1-2 punch on the agency mREITs.

Disclosure: No position in any security mentioned in the article.