Mortgage hedgers are unlikely to exacerbate the Treasuries sell-off this time around, according to JPMorgan analysts.
Where once Fannie Mae and Freddie Mac held and actively hedged massive mortgage-bond portfolios, the largest players now in the market are those who don’t, such as the Federal Reserve and non-bank servicers.
Mortgage bonds are continuously callable, so when rates increase, a mortgage portfolio’s duration — a measure of its interest-rate sensitivity — can rise dramatically, which necessitates rebalancing. When mortgage investors react to that, the trades they make — such as selling Treasuries — can worsen the very event they are trying to escape, adding impetus to rate sell-offs.
The potential for that kind of hedging could worry any mortgage-bond investor, as the duration of the agency MBS universe is extending after hitting post-2008 lows last year. Meanwhile, the overall weighted-average coupon of mortgages has dropped by 0.3% over the past six months, according to JPMorgan analysts Joshua Younger and Nicholas Maciunas.
But today the mortgage players who most actively hedged — Fannie and Freddie, real estate investment trusts and large bank servicers — have significantly reduced their need to to do so, the analysts added. The government-sponsored enterprises, for example, owned more than 20% of the market in 2003; they hold just 1.5% now.
Large banks have moved away from servicing mortgages, with non-banks, which rarely hedge, becoming major players in that space. Bank-serviced loans as a percentage of the universe have dropped to about 16% from 40% back in 2014.
REITs, whose hedging moves in 2013 had an outsized impact because they were caught off-sides, remain a relatively small player and are in a much better position now to handle a rate sell-off, according to the analysts.
U.S. commercial banks, due to the size of their holdings and infrequent rebalancing activity, “are the wildcard,” the JPMorgan analysts added.
It’s not the amount of mortgages so much as who exactly holds those mortgages that matters when trying to determine the level of hedging activity to come. With that in mind, the analysts expect “a fairly benign outlook” overall for mortgage hedging activity, with a repeat of the past unlikely.