MBS OPEN: 2008: The year of "too much of a good thing" for MBS

Once you get to the first plateau of MBS understanding, it seems generally accepted that negative scheduled or headline data is usually a good thing for MBS.  After all, if the economy is exhibiting weakness, one could conclude that a FTQ (flight to quality) bid should include the now-explicitly government backed MBS.  By and large, this has been the case, well, until 2008 at least.  If "negative data" has been a good thing, then 2008 has been the year of excess.  Take for instance, the headline that will dominate today's discourse: the failure of the auto bailout.  Negative right?  Stocks reacting badly right?  Treasuries improving from even their impressively low yields...  Past precedent suggests MBS should improve too.  But as has been the case so many times this year after abysmall data, they are not.

The moral of the story relates to one of the central concepts of MBS and mortgage rates = MBS and Treasuries have fundamental difference that render futile the application of identical analytical frameworks.  Whoa, whoa, whoa...  It's still kinda early...  In English please...  MBS and Tsy's are apples and oranges.  One of the key differences between the two is RISK.  For the most part, treasuries are considered to be utterly risk free, whereas MBS have both credit risk (well, not that much now that the conservatorship is on) and "call risk."  In other words, there is a risk that the loans underlying MBS pools can be "called" when the homeowner sells, refinances, or undergoes another form of less savory disposition.  In all cases, the investor's standpoint is the same (that's not to say that Fannie, Freddie, the servicer, and the MI company won't take a hit). 

So when the news is REALLY bad, it carries broader implications that investors feel might affect either the prepayment speeds or the credit risk in MBS.  Today's failed bailout is one such event.  To offer an actual example of what might go through an investor's head... "hmm...  the auto industry is a not-insignificant part of our domestic economy.  Not only does it employ numerous people in directly, but it is very interconnected with the broader economy as well.  If this bailout fails, there's a good chance the big three face bankruptcy.  From both a practical and psychological perspective, I don't see that IMPROVING the stability of the mortgage market, because a group of people will either have to sell, refinance, or do something worse with their properties.  Banks might suffer a little more so counterparty risk is high meanin the cost of credit will be high.  So if I'm a cash buyer of MBS, I'm worried about DURATION (the loans might pay off quicker) and if I finance my purchase, as most do, I'm worried about not having a high enough rate to recoup my financing costs.  (note: that's the reason the "credit crisis" has been so harsh to MBS spreads).  So I'm going to command a higher interest rate for anything I buy either way."

And there you have it.  Negative economic data actually hurting MBS.  Also, don't forget that there are times when MBS are improving compared to themselves, but really tanking compared to risk-free treasuries.  Either way, too much of a good thing, can be just that, and is one of the many examples of why one would not want to look at treasuries to get a gauge of mortgage rate direction.