Mortgage Bond Market Plagued by Valuation Doubts

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The Federal Reserves torrid pace of mortgage purchases over the past five months has helped send home lending rates to record lows and prepayment speeds 96% higher. This has created a daunting challenge for Wall Street modelers.

Mortgage-backed securities analysts at Morgan Stanley and Bank of America Corp. have recently warned that valuation models are less reliable with the precipitous drop in mortgage rates -- the 30-year average is now at 2.88% -- and the prepayment speed surge.

In its weekly report from August 7, Morgan Stanley strategists wrote that model uncertainty “is the highest now that we can ever remember it being.” Most notably, they added, “high model uncertainty also lends itself to the argument that you shouldn‘t be overweight (or underweight) an asset class that you can’t model correctly anyway.”

Morgan Stanley is currently neutral the mortgage sector.

Likewise, Bank of America in its July 31 weekly report warned “confidence in models is low” and that central bank mortgage buying has led to “valuations on the 2%, 2.5% and 3% that are divorced from fundamentals.”

Bank of America is also currently neutral on the sector.

This has a been a festering problem for mortgage investors since the second quarter. On April 17, the Wells Fargo & Co. MBS analyst team wrote, “the recent shock to the economy due to Covid-19 creates a challenging environment for prepayment modeling.”

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They added “with the Fed buying MBS at an unprecedented pace, TBA deliverable assumptions are going to be in a state of flux.” Wells Fargo is currently overweight the mortgage sector.

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Since March 16, the Federal Reserve has bought $920 billion in agency MBS, and it seems unlikely this round of QE will end anytime soon. In March and April, the bank purchased about $290 billion MBS per month.

That pace has since slowed to about $100 billion gross -- and $40 billion net -- per month, and the latest FOMC statement promised to keep buying “at least at the current pace.”

• Christopher Maloney is a market strategist and former portfolio manager who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice