This article is adapted from a speech delivered at a Mortgage Bankers Association conference this month.
Over the past 10 years, the mortgage securities market has been one of the faster-growing sectors of the U.S. capital market. The dollar volume of its outstanding issues increased 20% annually from $240 billion in 1983 to $1.45 trillion in 1993.
The market achieved this phenomental growth by constantly expanding its investor base through innovative creations of derivative mortgage securities.
Collateralized by single-class passthroughs, derivative securities segment the collateral cash flow into multiple-maturity classes. Additionally, derivative securities sometimes transform the fixed-rate coupon of the collateral to floating-rate coupons. They also occasionally decouple the colateral into interest-only and principal-only securities.
But the issuance of innovative securities inevitably crates "exotic securities" as a byproduct. The price and average life behavior of these exotic securities is potentially volatile, and it turned blatantly real in the past two years as prepayments accelerated to levels far beyond what investors has ever anticipated.
Cultivating New Investors
Already, changes in regulations and accounting rules have restricted the future investment in exotic securities by depository institutions. Thus, to continue its rapid growth, the mortgage securities market needs to cultivate new investors who are not only well capitalized but also sophisticated enough to analyze whether to take prepayment risk.
These derivative securities were first issued in 1983 in the form of collateralized mortgage obligations, and then more creatively sincer 1986 through real estate mortgage investment conduits.
As the mortgage-backed securities market rapidly expanded through the years, its investor base also diversified remarkably.
In particular, the pace of diversification was accelerated in the past five years by substantial delines in interest rates, the record steep Treasury yield curve, and heightened regulatory capital requirements for thrift institutions.
These events greatly increased the investment of mutual funds, individuals, and commercial banks in mortgage securities. The advent of derivative securities has steadily expanded mortgage investment by pension funds and life insurance companies.
Thrift institutions, the most important mortgage, investor prior to the mid-1980s, yielded thir position to banks and insurance companies for lack of capital.
Why Bond Funds Grew
Mortgage mutual funds flourished on declining interest rates. The 400-basis-point deline in interest rates of the past five years has fostered the growth of bond funds. Many individuals opted to purchase shares of bond funds rather than investing directly in bonds for two reasons.
First, they lack the time and the market information necessary for the management of their direct bond investment.
Second, in the midst of substantial declines of interest rates, they want to capitalize the bond-price appreciation.
Over the past five years, mutual funds' holdings of mortgage securities increased from an estimated $45 billion at yearend 1989 to $119 billion in mid-1993.
As a percent of all outstanding mortgage securities, the share of mutual funds holdings rose from 4.9% to 8.2%.
Dealer Inventories Rise
Over the past two years of record steep Treasury yield curve, dealers in mortgage securities markedly increased their holdings of mortgage securities.
Dealers are supposedly an intermediary to facilitate the funding of mortgage securities in the capital markets, although as underwriters, they do inventory newly issued single-class pass-throughs or multiclass Remics.
But over the past two years the 10-year Treasury notes yielded between 200 and 350 basis points over the three-month Treasury bills. With a huge spread between the funding cost (represented by the Treasury bill rate) and the investment yield (mortgage securities normally yield about 100 basis points more than the 10-year Treasury), there was a strong incentive for dealers to arbitrage along the yield curve by stockpiling mortgage securities.
By doing so, they behaved literally like permanent investors. At yearend 1991, dealers held an estimated $54 billion, or 4.3% of the total balance, of mortgage securities. By mid-1993, their holdings rose to $90 billion, or 6.2% of total.
Bank Increase, Too
Commercial banks expanded portfolio lending through mortages. Since the beginning of this decade, banks have aggressively invested in mortgage securities.
Coincidentally, this strategy to concentrate in mortgage securities was conventionally enhanced by the steepness of the yield curve. Their holdings of mortgage securities surged from $129 billion (14.1% of the total) at yearend 1989 to $335 billion (23.2%) in mid-1993.
By mid-1993, foreign investors had escalated their holdings to $150 billion, exceeding 10% of total outstanding mortgage securirities.
Pension funds and life insurance companies have also steadily expanded their mortgage investment. Combined, at yearend 1989, they held $213 billion of mortgage securities, or 23.2% of total. In mid-1993, their share of holdings rose to almost 31%, over $445 billion.
Shortage of capital forced thrifts to withdraw from mortgage investment over the last few years.
The forces that are altering the purchase pattern of various investors will have profound short-term implications on the relative prices of a variety of mortgage securities. In the long run, these forces are still expected to influence their relative prices, but the prevailing level of interest rates will be an additional factor.
As demand for various short and stable mortgage securities rises in the short run, their prices will rise. Their yield spreads over comparable Treasuries will tighten. Since these "nice" securities cannot be produced out of given collateral without the byproduct of exotic securities, the prices of long andf unstable average-life securities will decline.
In the long run, if interest rates continue to hover around the current level, the short-term relative prices will say put, but if interest rates rise or become persistently volatile, even the relative prices among PACs backed by a different coupon of collateral will vary.
In the short run, the overall mortgage-to-Treasury yield spread will widen. No significant increase in the supply of mortgage credit is on the horizon, but pent-up housing activity in the current stage of recovery is pushing up the demand for mortgage credit.
In the long run, however, the pricing of mortgage securities is a function of the overall supply of savings and long-term demographic demand for housing. During the 1990s, the aging of baby boomers is expected to produce more households with a declining propensity to spend.
This will generate more savings and increase the long-term supply of mortgage credit.
On the other hand, housing demand in the 1990s and beyond is expected to drop markedly as baby boomers pass their homebuying age. This will reduce the long-term demand for mortgage credit.
The implication of these trends is that mortgage rates relative to Treasury yields will eventually decline. In other words, the long-term yield spread of current-coupon Ginnie Maes versus the 10-year Treasury will tighten to much below 100 basis points.