Morgan Stanley
December 5, 2011
2012 Agency MBS
Outlook
Policy Uncertainty to Drive
Mortgage Valuations
Investment Themes: Our investment themes for the
agency MBS market in 2012 are centered on policy
uncertainty, which wil touch all facets of the mortgage
market - housing finance, supplyldemand, and
prepayments. Our top § investment themes can be
summarized as:
‘The macro envionment is positive for mortgages:
Conventionals likely to richen relative to 15s and GNs;
Lending capacity will limit the increase in overall speeds
but certain cohorts may pick up more than expected; The
{gap between slow and fast servicers will widen; and Lower
‘coupon rolls may trade special due to Fed purchases.
Housing Finance: We do not expect politicians to tackle
any tough issues such as GSE reform in an election year,
thus any progress related to housing finance reform will be
made around only certain targeted issues such as servicer
‘compensation restructuring. However, the mortgage
lending industry should continue its transformation due to
unintended consequences of policy actions from previous
years. n particular, the cofrespondent lending industry
may see significant changes,
‘Supply/Demand Technicals: For 2012, we expect gross
‘Agency MBS supply of $1.37 trlion in our base case
(average mortgage rate of 4%) and net issuance of
between -$20 and +$30 billon. We believe banks and
money managers willbe the primary buyers of Agency
MBS as the GSEs, Treasury, and overseas investors let
their portfolios shrink. SupplyiDemand technicals are very
positive, with QE3 in morigages as a potential wild card,
Propayments: The macro environment remains contiicted
for mortgage refinancings ‘rom the policy perspective. The
goal of HARP 2.0 and potentially QE3 is to boost
refinancings. However, regulatory uncertainty has resulted
ina secular decline in lending capacity, which limits the
benefits of policy easing. Our chief concern for 2012 is not
‘an aggregate increase in prepayment speeds but rather
faster than expected pickup in speeds for certain cohorts.
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‘Table of Contents
Oveniew
‘Transfoation of Mortgage Lending Industy Continues
‘SupetyDamand
Propayment Ook
“Top ivesment Themes fo 2012
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located at the end of this report.Morgan Stanley
December 5, 2044
2012 Agency MBS Outlook
2012 Agency MBS Outlook: Policy Uncertainty to Drive Mortgage
Valuations
Overview
The central theme for the Agency MBS market in 2012 is
policy uncertainty and it touches all facets of the mortgage
‘market - housing finance, supply/demand, and prepayments,
Despite these uncertainties, we believe the broader economic
backdrop remains very positive for agency MBS. Our house
View is that growth in the US will remain sluggish (2.2% in
2012) and home prices will drop 9-14%, which will combine to
keep rates range bound and cause Vega to fall moderately
All these factors are positive for the mortgage basis.
Within the context of housing finance reform, the servicing
‘compensation restructuring is likely to gain traction in 2012.
Dramatic change in the compensation structure could cause
the negative convexity of mortgages to worsen not only for
‘new production but also for ex'sting collateral. Ifthe FHFA
decides to pursue @ more dramatic change in servicing
compensation structure, they may use a phased approach to
Implement these changes.
Mortgage lenders are shrinking their footprint in response to
recent regulatory changes and ongoing legal challenges. This
trend is negative for the macroeconomic environment as it
hampers the transmission mechanism of easy monetary
policy to the economy. However, stagnantlower lending
‘capacity is supportive for mortgage valuations as it imits the
aggregate prepayment response and may also limit the
success of HARP 2.0. In particular, the correspondent lending
business is becoming more consolidated and could see some
significant changes in 2012.
‘The supply demand technicals are very positive for agency
MBS. We expect banks and money managers to be the
primary net buyers of agency MBS in absence of QE3. The
amount of agency MBS that needs to be absorbed by private
market participants is fainly modest. In case the Fed launches.
QE3 in mortgages, we expect money managers to be the
primary sellers of agency MBS to the Fed. In that scenario,
We would expect 30-year conventionals to outperform 15-
years and Ginnies and lower coupons to outperform higher
Coupons. This would effectively reverse the trend since the
lend of QE (exhibit 1), which led to cheapening for 30-years
relative to rates and 154yeariGinnies,
Nominal Spreads Have Widened Since the End of
Qe1
FNGL GG - USTIO¥ Vield Spread os)
“The environment is rather conflicted for mortgage refinancing
from the policy perspective. The goal of HARP 2.0 and
potentialy QE3 is to boast refinancings. However, regulatory
uncertainty has resulted in a secular dectine in lending
capacity, which limits the benefits of policy easing. In our
view, how lenders decide to allocate origination capacity in
such an environment wil be the key source of uncertainty for,
mortgage prepayments in 2012. Our chief concern for 2012 is
not an aggregate increase in prepayment speeds but rather
faster-than-expected pickup in speeds for certain cohorts.
Investment Themes for 2012
‘Sluggish economic growth and weak housing increases the
liceinood of QE3 in mortgages and limits the prepayment
response. Range bound rales and falling Vega combine to
create an ideal environment for owning mortgages, in our
view, allowing investors to pick up significant carry. Weak
{grow in particular is positive for banks’ demand for Agency
MBS as C&l loan growth remains tepid. Our top five
investment themes for 2012 are as follows:
1. Macro environment positive for mortgages ~ Own the
mortgage basis
2. Conventionals to get richer relative to 15-year and GNs ~
‘Overweight 30-years relative to 15-years initially and
relative to GNs late.
3. Lending capacity will im increase in aggregate speeds
but certain cohorts may pick up more that expected ~Morgan Stanley
‘Own large diversified pools rather than TBA in higher
‘coupons.
4, Slow servicers wil continue to lag faster servicers —
Prefer Bank of America serviced collateral for higher
‘coupons.
5. Lower coupon rolls may trade special due to Fed
purchases, stick with low pay-up Specified Pools in 4s.
Transformation of Mortgage Lending
Industry Continues
‘Changes - Intended and Unintended
‘The mortgage lending industry continues to be in the midst of
undergoing structural changes such as the tightening of,
lending standards by lenders, GSEs, FHA, and Mls in
response to the housing crisis was the story of 2008-2010, the
inabilty of politicians to tackle GSE reform and lack of
Urgency among regulators to define requirements for Qualified
Residential Mortgage (QRM) and risk retention, was the story
of 2011. As a result, the government continues be the primary
bearer of mortgage credit risk in the US. Given the election
cycle, we don’t expect politicians to tackle any tough issues in
2012 either. Therefore, we expect thatthe progress related to
housing finance reform will be made only around certain
targeted issues, However, we expect the mortgage lending
industry to also continue its transformation due to unintended
consequences of policy actions from the past couple of years.
Intended Changes - Servicer Compensation
Restructuring
‘The single most important change driven by regulators/GSEs
that could materialize in 2012 is servicer compensation
restructuring, in our opinion. On September 27°, the FHEA
published a discussion paper in which they outined two
proposals for servicer compensation restructuring. The
comments on the two proposals are due within 80 days ofthe
publication date
‘The frst proposal, which we would call a compromise, is
based on the ideas that were put forward by Mortgage
Bankers Association (MBA) and The Clearing House
Association. This proposal reduces the minimum MSR that
the lenders would need to retain from 25 bps to 12.5-20 bps.
To align the interest of lenders with the GSEs, and to Increase
focus on servicing of non-performing assets, there is a
provision for locking up a small portion (3-5 bps) af the
Interest stream into a trust. If the credit performance of
‘mortgages is better than the average then the servicer would
December 5, 2044
2012 Agency MBS Outlook
be able to claim full/partal refund from the reserve account
“The goal ofthis structure isto help the lenders meet the Basel
I requirement by lowering the minimum required retained
MSR. To alleviate investor concems around churning, this
structure does not reduce the MSR too much and keeps the
‘economies of the solicitation decision forthe lender fairly
clase to where itis right now. This proposal changes the
current servicing compensation model modesty and its not
clear to us whether these changes are sufficient from the
perspective of regulators.
“The second proposal, which represents a fundamental
change, effectively eliminates the need for servicers to
capitalize MSR, Under this proposal the servicers are paid for
their work on a pay as you go basis or Fee for Service (FFS)
In this scenario, GSEs get a much better control on servicing
especially when a loan becomes delinquent as they can
adjust compensation to incentivize servicers to meet their
objectives. MBS investors are most concemed about increase
in negative convexity of the MBS universe under this
proposal. To alleviate these concems the FHFA has proposed
adding a few hurdles to reduce the refinancing efficiency.
In our view, the regulators want to use this opportunity for a
‘more dramatic reform as opposed to modest ineremental
changes. We think thatthe regulators would lke to implement
a version of the second proposal after modifying i to alleviate
‘market concems, However, regulators are concerned about
the disruption such a change may cause to the MBS market.
Therefore, they may take a cautious approach possibly by
launching a pilot program fist
Although market participants are concerned about the
negative convexity of MBS issued under the new
compensation structure, we are additionally equally
Concerned about increases in callabilly ofthe existing MBS.
Servicers would be incentivized to shift borrowers whose
probability of default is expected to be higher to the new
‘compensation rogime to benefit from the higher compensation
for non-performing loans in the FFS regime. This dynamic
could be even stronger if servicers can reduce their reps and
warranty liabilties under a modified HARP.
Unintended Consequence - Lending industry could
shrink further
Aside from structural changes in mortgage servicing
compensation structure, alot of changes in the mortgage
lending industry are occuring simply due to unintended
consequences of recent regulatory changes and legal