Mortgages a ‘Good Place’ to be Overweight, TCW’s Flack Says: Q&A

Mitch Flack, a managing director at TCW Group, Inc., says that due to agency mortgage bonds’ robust liquidity and lack of credit concerns, the sector is “a good place to be slightly overweight.”

Flack, who is head of agency MBS with TCW’s fixed income group that manages over $210 billion, spoke with Christopher Maloney in a series of interviews ending March 30. Comments have been edited and condensed.

Mortgages a ‘Good Place’ to be Overweight, TCW’s Flack Says: Q&A

What have been the main drivers of recent agency mortgage performance?

The main drivers at this time are the Federal Reserve in the lower coupons and fast speeds higher in the stack. It’s been just over a year of renewed quantitative easing, and performance since it started has been very good, particularly in the targeted lower coupons.

The lower coupons, however, have recently come under pressure due to the potential for a sooner than expected Fed QE taper. This scenario may not play out exactly how the inflation hawks believe. I’m not sure the changes we’ve seen with the lockdowns are going to be completely reversed, and the Fed is focused on the still elevated unemployment rate.

Do you expect these drivers to remain in place over the near term?

I would anticipate with the increase in rates that the Fed will move up the coupon stack as they always target the production coupons. They are now likely to shift their focus away from the Fannie Mae 30-year 1.5% to the 2.5%, though they will continue to focus on the 2%.

As for prepayment speeds, we learned during the pandemic that non-bank originators are extremely innovative and barely missed a beat. They have become even more efficient in their use of technology. This has shifted the S-curve higher and steeper for in-the-money coupons to refinance. Burnout has not shown up as quickly as expected in the higher coupons.

What do you foresee as the Federal Reserve’s time line for an eventual taper?

It is extremely difficult to predict what an independent agency will do, but they may reduce their current pace of adding $40 billion in agency MBS per month either late this year or early next year.

The taper period will be a prolonged one, perhaps a year or more. I don’t anticipate they will stop reinvestment in the foreseeable future. This is not something they can get out of quickly.

On a relative basis to competing products, do you feel agency MBS merit an underweight, neutral or overweight?

It’s necessary to perform a deep dive into sector valuations and the one big technical, which is the Fed. The central bank has provided unprecedented support which has led to very attractive rolls and implied financing rates.

The Fed has cleaned up the float nicely in the lower coupons and added to their balance sheet – which has added to banks’ excess reserves – which has given the banks incentive to boost their mortgage purchases. They, along with the Fed, absorbed all net issuance last year.

The superior liquidity and credit profile of agency MBS suggest the sector is likely a good place to be slightly overweight.

Is there any chance the Biden administration will push for the end to GSE conservatorship during this term?

That’s a very low probability event. The latest PSPA requires that the GSEs have a common equity Tier 1 capital of about 3%, which means they would have to raise about $200 billion in capital.

The new administration also seems more interested in affordable housing. Of particular interest is if the current FHFA director Mark Calabria stays on board? If he is replaced, that will be the nail in the coffin for whether the GSEs remain under conservatorship.

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