At the Federal Open Market Committee's meeting in late September, its statement indicated that it would slow the pace of its MBS buying, extend the purchases through the end of the 1Q10 and buy the entire $1.25 trillion.

In the weeks prior to the adjustment, the Fed had been buying an average of $5 billion per day. It slowed the pace down to $4 billion per day in the three weeks following the statement, and in the last report for the period Oct. 15 through 21, the Fed's daily average dropped to $3.6 billion, or $18.1 billion for the week. To date through Oct. 21, the Fed has bought $959.1 billion. With about $291 billion left, this equates to a weekly average of $12.6 billion.

Most analysts expect, however, that the Fed's weekly average buying will likely be higher than the more than $12 billion through year end as it attempts to avoid a sudden disruption to the market when its exits the sector.

JPMorgan Securities analysts, for example, expect the Fed to buy $60 to $80 billion per month through the end of 2009.

Despite the Fed's slowdown, supply/demand technicals are projected to remain very favorable over the near term, especially as MBS issuance has been declining recently. Bank of America Merrill Lynch analysts expect that Fed purchases are likely to overwhelm net issuance by a factor of 2 - at least for the short term. Likewise, JPMorgan analysts also project a similar factor and possibly higher as they forecast monthly net supply to total in the $30 to $35 billion area.

Heading into 2010, spreads are expected to leak wider as fundamentals take over and investors require a higher return for their risk. Credit Suisse analysts calculated that the MBS basis to 10-year Treasurys should eventually widen to around 115 basis points over a gradual three- to four-month process.

Spreads currently are around 90 basis points over the 10-year Treasury note.

Analysts added that while it's possible that spreads will peak at a higher level, they anticipate that the basis will settle tighter than the long-term average of 120 basis points given the projected high percentage held by the government sources.

JPMorgan analysts said that, over the next six months, the sector will have to widen around 20 to 25 basis points on an OAS basis to reach a level that will attract private investors and to make the sector an attractive alternative to high-grade corporates and prime non-agency MBS.

Barclays Capital analysts estimated a knee-jerk widening of 30 to 40 basis points at the end of the Fed purchases, but then for spreads to gradually tighten, in part, as they anticipate limited supply in the spread sectors in 2010.

 

Early Outlooks for Future Supply and Demand

Barclays is currently projecting agency net issuance to total $360 billion, or $30 billion per month, in 2010, similar to 2009. They project additional supply of $15 billion from Fed/GSE portfolio runoff. With the Fed out, will banks, overseas and indexed funds pick up the slack?

Barclays expects that banks could add $200 billion or more over the next 12 months in agency MBS, up from $100 billion so far in 2009, in part because banks traditionally have increased their securities portfolio in the year following a recession. Other factors supporting buying in agency MBS are expectations of a continued steep yield curve and a lack of other triple-A alternatives such as non-agency and commercial MBS.

Deutsche Bank Securities analysts are not so sanguine on this. "Banks are unlikely to expand the volume of credit and their exposure to the MBS market," they said.

Analysts noted that MBS portfolios have grown, but not by much, especially compared to Fed and money manager buying. Additionally, they pointed out that much of the growth that has occurred has been from "healthier small banks," while the top four banks that make up 49% of total MBS holdings have actually reduced their MBS holdings after accounting for mergers.

Also, looking at bank MBS exposure on an mark-to-market basis, "the MBS basis exposure of the top four banks has actually gone down substantially" as a result of consolidation of the servicing business into these four banks.

At this juncture and with uncertainty regarding bank capitalization and regulations, Deutsche analysts do not expect investors to want to invest in the banking system. As such, they didn't see credit availability improving or consumer demand picking up.

They don't think that, "the banking system will be able to support the mortgage market when the Federal Reserve ends its MBS buying program," they said.

Overseas buyers are expected to purchase $100 billion in MBS in 2010, which comes to around $10 billion per month, Barclays analysts estimated. They anticipate risk normalizing among international investors. Analysts also project Index money would be in line with bank buying, if spreads widen enough to be a competitive advantage to other sectors. They estimated that Index money needs spreads to widen 25 basis points to encourage their interest in the sector.

Is there any support that can be expected from the GSEs? Year-to-date through September, Freddie Mac's retained portfolio is down $21.0 billion to $784.2 billion, and Fannie Mae's is down $7.9 billion to $779.4 billion as of the end of August - despite the increase of their portfolio cap to $900 billion this year.

The decline in the GSEs' retained portfolios raises questions such as whether they are simply being proactive in their requirement to begin reducing their retained portfolios beginning in 2010. Was the reduction done to make room for delinquent and modified loans that these agencies might have to take onto their balance sheets or tight OAS levels?

Many analysts do not expect the GSEs to return unless there is a sharp OAS widening. In a mid-September report, JPMorgan, analysts suggested that OAS widening to Libor plus 20 basis points or so would bring around $20 billion per month from the GSEs.

Also influencing these firms' activity is the need to make room for delinquent and modified loans. Credit Suisse analysts projected that both GSEs together will have to sell between $70 and $200 billion through 2010 as a result of the buyouts of modified loans and delinquent loans that have reached the 24-month maximum limit.

In addition, the GSEs will be required to reduce their retained portfolios annually by 10% beginning in 2010, which equates to around $150 billion based on the current size of their portfolios, said analysts. In total, they calculated that the GSEs will need to reduce their existing portfolios by approximately $360 billion by the end of 2010.

They expect, however, that the GSEs will be able to accomplish a large portion of this through paydowns. However, if rates sell off, they said it might require them to have to sell between $125 and $200 billion to make up for the shortfall.

(c) 2009 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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