(July 2012) Akiva Dickstein is a Managing Director and Head of Mortgage Portfolios at BlackRock. BlackRock has two mutual funds focused on mortgage backed securities (MBS). One is specifically focused on government backed, Ginnie Mae securities (BGPAX). The other fund, The US Mortgage Funds (BMPAX), includes both agency and non-agency mortgage backed securities. As a result of taking on more credit risk, the broader MBS fund delivers a moderately higher yield than the Ginnie Mae fund. Despite a collapse of the real-estate market, BlackRock’s US Mortgage Fund had an average total return of 8.25% per year over the last 5 years, significantly beating the Lipper US Mortgage Fund Average of 5.62%.
Recently, Learn Bond’s had a chance to interview Dickstein to try and get an understanding of the key issues affecting Mortgage Backed Securities:
LB: What is prepayment risk and why do prepayments occur?
Dickstein: Mortgage Backed Securities are composed of thousands of loans. When one of these loans is paid off early, the owner of the mortgage backed security will receive 100% of the loan’s remaining principal. However, if the Mortgage Backed Security was purchased at a premium to the value of the principal, the investor in the MBS will take the loss of premium for that loan. As most agency Mortgage Backed Securities are currently trading at premiums to their principal value, this is a major risk.
There are natural reasons for mortgage prepayments, such as a family moving from one home to another and selling their original residence. In the 1990s, the prepayment rate was in the high single digits. The following decade the percentage of prepayments rose dramatically as housing values climbed. Many homeowners refinanced specifically in order to take equity out of their houses. More recently, prepayments have been driven by borrowers taking advantage of lower interest rates to refinance their mortgages. Government programs have also helped some borrowers refinance their loans.
LB: Could you be more specific about the current market situation and how you minimize the impact of prepayments on your funds?
Dickstein: We are seeing a number of high-quality borrowers refinance to save on interest rates. For example, an MBS that has a 4% securitized interest rate (which means the borrower is paying around 4.5%,) includes borrowers that can save 75 bps (3/4 a percent) by refinancing at today’s rates. In this case, we are seeing annual prepayments in the mid 30 percent range. On the other end of the spectrum, we are seeing borrowers with less strong credit histories take advantage of the government HARP 2.0 program, which enables those that are underwater on their mortgages to refinance at lower rates. In some vintages of MBS where there is a concentration of HARP eligible mortgages, and higher than market interest rates on those mortgages, we are seeing prepayment rates as high as 43% on average (and higher for certain servicers).
We are finding lower prepayment rates with mortgage pools that have lower interest rates (this gives them less incentive to refinance), and those with higher interest rates which contain older loans.
LB: Is there a difference in prepayments between Agency and Non-Agency Mortgage Backed Securities?
Dickstein: Before the financial crisis, there was relatively little difference between agency and non-agency prepayment patterns. However, over the last few years, prepayment rates for agency MBS have been much higher than non-agency. Borrowers that do not conform to agency standards have great difficulty getting loans as the market for non-agency mortgages has shrunk tremendously since the financial crisis. Banks are now very hesitant about granting mortgages that don’t conform to agency standards.
LB: What do you think returns will be for investments in non-agency MBS as a category over the near future?
Dickstein: Our models, which incorporate our expectations on prepayment rates, default rates, interest rates, and housing values suggest a total return of 6-8% for investors in non-agency Mortgage Backed Securities. We believe there may be upside to these numbers if there is a housing market recovery. If you are comparing investing in a non-agency MBS to high yield corporate credit, you might want to consider that high yield corporate credits currently have around a 2% default rate which is low by historical standards. If this rises, the expected return would fall. Non-agency MBS already prices in the weak housing market.