3Q 2023 Fixed Income and Mortgage Market Commentary

Watching CNBC one morning, I caught a ten-minute segment where Rick Santelli talked about rate moves on the back of the employment data, followed by the youthful talking heads talking about the shocking backup in the curve – 30 bps in under two weeks! – and the capped off with Jim Cramer giving an anecdote about comparing Coke and Pepsi stocks forty years ago as a junior analyst at Goldman. And it occurred to me that, depending on when you started your career, you end up having a set of experiences that govern what your intuitive brain will expect: 
⦁ Rick Santelli: You started your career in the 80s, in which case volatility and “high rates” are fine, but subject to a normal range; or,
⦁ CNBC Anchor: You started your career in the 90s, in which case rates generally fall whenever they go up a bit, but trend down over long horizons; or,
⦁ Most MBS Traders: You started your career in the 00’s, in which case you think rates are broadly supposed to be at or near zero.

Unless you started your career in the Johnson administration, however, your go-to, ingrained-at-the-start sense of what the curve “should” do will not be “rates generally drift higher.” Well, welcome to the Johnson administration: inflation is trending higher as the government spends on guns (Ukraine, Taiwan, Israel) and butter (the Inflation Reduction Act); relative money supply is shrinking during a relentless low unemployment cycle; and we’re seeing the beginnings of a productivity wave that will have uncertain effects on employment and wage growth.

“Isn’t this an MSR commentary,” you may ask? Yes, of course it is – but remember the last time this financial and macroeconomy existed, there was no mortgage securitization market. Lou Rainieri, in 1967, was only just starting to wear wide brown ties with badly matched striped shirts. Bond traders didn’t do math – they looked up prices on rate sheets the same way they’d look up a number in a phone book (Google both). The MBS market as we know it, in other words, has never lived through a period like the last two years – but interest rates have. And since we don’t use rate sheets, we use YieldBook and Bloomberg and Excel, we can model what should happen going forward.
First though, a little look back. Q2 2023 will be remembered as the beginning of the full-scale renormalization of the curve. The Fed’s activity in 2022 was aggressive, but the back end made everyone feel like “well, maybe this is just a fix it”. Powell and his fellow mouthpieces couldn’t say it loud enough – this will be higher, for longer, and that’s a good thing – so markets kept waiting for signs of a return to ZIRP. This quarter, though, was capitulation, the ugly early stage of capitulation where markets realize they got it wrong but are close to when they were wrong and therefore are still sort of embarrassed about how dim they look as many stories emerged about whether the world could survive higher rates as anything about how it would happen. The 10y is now ranging towards 5.0%, having drifted upwards from 4.3% in mid Q2, with effectively no real movement in the 2-year rate except to reflect the most recent two Fed moves.
 The bear steepener we’ve witnessed is probably not done yet, as inflation remains stubbornly above 3% and inflationary pressures remain high – low unemployment and high deficits being the temporary rule of the day.  The mortgage basis, though, also remains high – despite the fact that high headline rates are killing mortgage origination volumes and thus rapidly drying up profitability among originators. Servicing income – and MTM increases in legacy MSR values – are seemingly the only positives for the non-bank players, and even for many of the bank originators who are suffering from NIM compression and MTM losses, realized or unrealized, on securities portfolios.  
But if we imagine a future where the short end is anchored – as I was taught – in a long term normal Fed Funds rate equal to nominal GDP growth plus expected productivity growth, the long end was normally positively sloped at 10-15 bps per maturity year out to 15 years, and mortgage basis was set off the 10 year based on a long term average correlation with the vol pricing of 3×13 swaptions, we are actually getting pretty close to normal. The 10 year needs to back up another 150 bps to be truly normal, but what will likely happen is the 10 year will back up 50 bps and the 2 year will drop 100 bps over the next 18 months. That will give us Fed Funds expectations of around 3.75% – exactly what the Fed wants us to think – which is roughly nominal GDP plus a drifting higher productivity level. The 10 year will be in the 5.5% range, and vol should come down, creating a mortgage basis of not 300 bps, but more like 150 bps – and leaving the par 30 year rate around 7.0%. 
For the mortgage market, that will lead to a kind of trickling Goldilocks environment. Trickling, because unless home prices actually fall, affordability means there won’t be much new origination, and only the bravest of renovators will refi or cash out refi from even recent origination into a new loan. Volumes will lag, and originators will continue to staff down, sell out, or go out of business. MSR buyers, though – even at more recent WACs in the high 5-low 6% range – should see lower than normal CPR rates well into 2025, along with robust escrow income. Delinquencies and defaults should also remain as they have been, in a historically low range since the Covid forbearance scare. All in all, it’s still a good time to own and be layering into MSR positions, both base and excess, although value will continue to be concentrated into base pieces. 
As for MBS more broadly, we finally like current coupons again, after having been biased towards highly seasoned 3.5-4.0 coupon paper going back for over a year. Spending the time in this market to make bets in specified pools is always worth the efforts – especially give the size of the super pools during the last refi wave and the demographic changes that are sweeping across the borrowing market in the wake of the structural restructuring of the US domestic workplace economy. But today, buying into new origination 6.0-6.5% pools, with a focus on bank originators away from the West Coast (and in New York if you can find the paper), will be viewed smartly in the near future. 
In the non-QM space, those demographic changes also have us looking for New York, New Jersey, and California new purchase paper in the just-slightly higher than jumbo balance tiers with full documentation – basically, if you’re buying that home today, in those locales, you’re making a statement because it’s too easy to move to Austin or Tampa. Low doc or stated income paper will have more hair than usual, and we like non-judicial foreclosure states right now in particular, as political uncertainty often leads to backups in litigation and to trigger-happy legislatures changing priorities for judges on the bench. But coupons remain very attractive, and non-QM in general is still a critical focus for Grander looking forward. And by “attractive”, we mean high coupons for investors – non-QM borrowers will be exercising the same budgeting skills that Americans first honed back in the Carter administration. 
Closer to home, please join me in welcoming Dave Hass to the Grander team – he’s running our secondary markets efforts to acquire and manage our MSR portfolio from our favored sellers. Dave and I are both of the 90s “Gen X” cadres of MBS traders, but we also seem to share a love of history that makes us respect Paul Samuelson and all the bond traders who navigated Nixon’s drop kick of Bretton Woods. We’ll report on how year-end shaped up, and give a fuller insight into 2024, when we present Q4’s analysis in January.

About Grander
Grander was formed in 2017 as Grander Investment Management LLC and Grander Mortgage Capital LLC by co-founders, Robert Williams, and Curtis Williams. Combined they bring 60+ years of Banking and Capital Markets relationships forged over multiple economic and market cycles. Established as a Master servicer in all but four states, Grander has secured State and Federal license approval as an “approved” seller servicer for Fannie Mae and Freddie Mac loans. Consideration to obtain GNMA approval in the future. Grander has partnered with strategic organizations on Subservicing and Recapture programs seeking to build long-term relationships and ensuring that recapture economics and incentives align across all parties.

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Grander’s mission is to foster life-long client relationships based on a foundation of trust and client satisfaction. Our value is supported by our seasoned investment professionals who have successfully managed investment portfolios throughout their career, bringing a unique perspective with diverse backgrounds, experience, and knowledge of financial markets. We strive for opportunity to access value creation outside the public markets within the Mortgage Service Rights space. Grander continues to develop future-oriented investment solutions and invest the assets of our clients responsibly and risk adverse.

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