The agency bond market is likely to post its worst performance in six years, but Salomon Smith Barney has figured out a way to make the most of that dire situation.

Callable agency new issuance volume year-to-date is $59 billion, a steep 59% plummet from the $142.4 billion posted at this point in 1999, while the actual number of new issues has fallen by 40%, according to Thomson Financial Securities Data. Barring an explosion of new deals in the next month, which seems very unlikely, this year will have the slimmest agency callable debt market since 1995.

Analysts said a combination of political uncertainty and most of all a series of Federal Reserve interest rate hikes earlier this year have helped to shrink the agency market. Fannie Mae and Freddie Mac came under fire for their investment strategies earlier this year by Congressional officials. Although a compromise was reached in the fall that enabled the agencies to proceed without fear of having their investment strategies constantly challenged, the instability may have driven some agency buyers out of the market and depressed trading, bankers said.

As one would expect, most Street players in agencies have seen their market standings tank in tandem with the overall market slump. That is, except for Salomon, which is now the second-ranked underwriter in the overall callable agency market, with a 9.8% market share, up from ninth place and a 4.4% market share in 1999. There is a good chance Salomon could still knock out current leader Morgan Keegan to become the top agency underwriter of 2000.

Salomon has made a huge leap in underwriting deals from the Federal Home Loan Banks, moving to third place year-to-date from ninth place in 1999, while its market share has risen to 8% from 2.8% in that time. Similarly, Salomon is tops with Freddie Mac agency issuance, where it is now the premier underwriter year-to-date, compared with its fifth place showing in 1999. And it is in fourth place for Fannie Mae bonds, compared with tenth at this point last year.

A Roller-Coaster Ride

While Salomon's rise is startling, it is not unprecedented. The fortunes of underwriters in the agency market rise and fall much more quickly than in rival debt sectors. Whereas Donaldson, Lufkin & Jenrette dominated the junk bond market for more than half a decade, for example, there has been a new top underwriter in the agency market every year since 1995.

Kingpins can become also-rans in the space of months. For example, Goldman Sachs has gone from being the top underwriter of callable agency debt in 1998 to its current tenth place, having brought $2.2 billion in new deals so far this year compared with $10 billion in 1999.

Salomon's story is no different. The shop was at the top of its game in the mid-1990s, having steadily risen in the league tables until it was crowned the top agency bond underwriter in 1996. Almost immediately, however, Salomon tumbled, sinking to fifth place in 1997 and tenth place in the following year. Its market share had compressed from 12% in 1996 to roughly 4% in 1998.

Market players said that standings in the agency market are so fluid it is hard to pinpoint why exactly certain Street shops fall out of favor. One banker speculated the confusion generated during the merger of Citibank and Salomon in 1997 may have cost the shop some agency deal mandates in that period, but that as the new Citigroup has become more streamlined and effective in the debt markets, its agency standings returned to form.

Agency Sleeping Sickness

The agency market is in good company for having a down year in 2000, with MBS, corporates and equities all suffering, but its performance is surprising because of the agency market's gangbuster growth rate, which had showed no signs of dissipating at the end of last year.

Throughout the 1990s, the agency market seemed to be an express train, breaking issuance records with each year. For example, all callable agency deals issued in 1996 totaled $81.1 billion, up 21% from 1995. For the rest of the decade the market blew past that total each year, culminating in the harvest season of 1998-1999, when the industry had two consecutive $150 billion-plus years.

But the rate hikes earlier this year have slammed the brakes on the mortgage market, hence the agency market, too. The dwindling in agency debt has also reduced its potential to become a legitimate replacement for Treasury bonds as a bond pricing reference. Several traders said that any inroads agency issuers made in the market in 1999 were erased this year because issuance dried up so suddenly. A main concern about the viability of agency debt as a market benchmark has been that there will not be enough regular new issuance.

Agency debt could still be considered a viable alternative to Treasurys, but damage has been done. The recent political compromise "puts agencies back in the running but they're way behind," said Michael Youngblood, head of mortgage research at Banc of America Securities. "It will take them a year or more to requalify as an alternative. Swaps are clearly the preferred instrument, as issuers are even pricing home equities to swaps now."

In the past, officials at both agencies have said they regard the benchmark note programs as just another service for their customers, rather than the centerpiece of a broad debt market strategy. If not for recent market troubles, however, "I think Fannie and Freddie could have been by now in a horse race with swaps to be the reference note for all taxable fixed income securities," added a mortgage trader.

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