BNP Paribas Asset Management - Agency Mortgage Market

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  • 06 mins 45 secs
John P. Carey, CFA, Head of Structured Securities, discusses what rising rates mean for the Agency Mortgage Market, the current political landscape, changes made in the US Mortgage Market, US Mortgages vs US High Yield vs UK Bond Market and the impact of the Fed's tapering on asset purchases.

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PRESENTER: Amidst a backdrop of political noise and economic uncertainty, I’m now joined by John Carey, who’s the Head of Structured Securities for BNP Paribas Asset Management, to discuss his outlook on the agency mortgage market. Well, John, good to have you with us today.

JOHN CAREY: Nice to be here, thank you.

PRESENTER: So let’s start with rate rises, and if the Fed does normalise rates in the next couple of years, what would this mean for the agency mortgage market?

JOHN CAREY: So I think a lot of investors today have been concerned about the Fed, and the idea that they’re going to start to taper their asset purchase programme and the implications for mortgages. In our view, this is not new news. This is something we’ve been dealing with really since the election, when mortgages and investors in particular came to the conclusion that the Fed was going to start to slow down their asset purchases, and eventually be a less important source of demand for mortgages. Moving forward in our view the lack of demand for these assets and for treasuries coming from the Fed is going to lead to a gradual and gentle rise to term structure of rates in the US, and maybe slightly wider mortgage spreads. In turn that’s going to lead to less supply of mortgage-backed securities, and we think this is pretty well priced into asset values right now in the mortgage market.

PRESENTER: And let’s look at the political landscape, and obviously the inconsistency of Donald Trump could lead to instability in the United States, so is there any signs that Congress may no longer support conservatorship?

JOHN CAREY: Well I think interestingly enough there’s been an evolution through time. If you go back just a couple of years, many of the Republicans were the Government should have nothing to do with the mortgage, the tax payers should not be on the hook for any of these mortgages. And I think through the evolution, we’ve seen more and more of the political class from Washington agree that it’s important for the government to back these mortgages, very important for our investor base, very important for investors from outside the US to know that we have that full faith and credit guarantee for these mortgage assets. So I would say through time there has been an evolution to the point today where I think there is a consensus around the idea that we need to continue to support the mortgage market through the agencies, through Fannie, Freddie and through Ginnie.

PRESENTER: And 10 years on from the financial crash of 2007/2008, what changes have been made in the US mortgage market and what lessens have been learned?

JOHN CAREY: Well I think number one is to not lend money to people who have no intention or ability to pay you back. So the underwriting standards we have for these mortgages are greatly improved. We’re requiring a minimum down payment of 20% from borrowers in order to get a Fannie and Freddie guaranteed mortgage. So the credit quality, we’re looking at the bank statements, tax returns. We’re doing verification of income, verification of employment. The concept of NINJA loans, the no income, no job, no asset that we learned about in the big short movies and books, really doesn’t happen today. We are verifying all of these things with the borrowers. So the underwriting standards are very strong. Employment pictures are very good in the US. People are paying their bills, home prices are going up. So much different picture than it was 10 years ago.

PRESENTER: And looking at liquidity, many commentators are predicting a dramatic change in the liquidity profile for credit markets around the world, which means there’s probably going to be a preference of holding cash to not take on that risk. So is it time for investors to run for the door?

JOHN CAREY: Well the thing is about the mortgage asset class is that does satisfy a lot of the requirements for banks and official institutions, as it relates to the regulatory framework, whether it’s Basel III. In the US, we have a term called HQLA, the high quality liquid assets. So the mortgage asset class, those guaranteed by the agencies, by Fannie and Freddie and Ginnie tick all these boxes as it relates to the regulatory framework and the liquidity and the asset test. So mortgages is probably not a bad place to hide out in this evolving regulatory framework.

PRESENTER: And how do US mortgages compare to say the US high yield or the UK corporate bond market?

JOHN CAREY: So corporate debt and those investments and securities that have a credit component to them have much more onerous charges; in some cases, we find 100% capital charges for some of the credit securities. Ginnie Mae for example is a zero risk weighted asset under the Basel III framework. So the mortgage asset class, those guaranteed by Fannie, Freddie and Ginnie really has got a much better treatment from the regulatory framework than any of the corporate assets.

PRESENTER: The UK investor has typically been quite underweight in the US mortgage market, so who holds that $5.5trn worth of assets, and how diverse is that investor base?

JOHN CAREY: So it is a favourite asset class for banks, and obviously the Fed is very important in our mortgage landscape right now. But you have to remember as the Fed is shrinking its mortgage assets, it has a liability on the other side of its balance sheet, and that is excess reserves. The excess reserves are an asset on bank balance sheets, and as their excess reserves go down they’re going to have to look for other high quality liquid assets to replace those excess reserves. There are really two securities that fit that bill: one is US treasuries and the other is agency mortgages.

PRESENTER: And let’s end on tapering. So what will be the likely impact of the Fed’s tapering on asset purchases, and has this already been priced in?

JOHN CAREY: Yes, I think for the most part it’s been priced in. The mortgage asset class underperformed in a pretty meaningful way just after the election last year as rates rose, and investors really bought into this idea that the Fed was closer and closer to this taper, so a lot of that I think is priced in. We see a gentle and gradual rise to interest rates in the US, the entire term structure. Ultimately that’s going to be beneficial for mortgage investors because it’s going to mean slower rates of prepayments, less supply. We still see strong interest from the banking community in the asset class. And in general money managers have been overweight the credit sector, and we’ve seen credit spreads really at the post crisis financial heights, so they’re underweight mortgages relative to benchmarks. We think there’s an opportunity for money managers to get back to neutral weight, maybe even overweight the mortgage asset class. So there are good sources of demand for mortgages, even though the Fed is now starting to step away from the market.

PRESENTER: John, thank you.

JOHN CAREY: Thank you very much.