With the continued easing of lending standards and terms for C&I loans - according to a recent Senior Loan Officer Opinion Survey on Bank Lending Practices released by the Federal Reserve - the issue of MBS bank demand arises again.
In recent research, MBS analysts have noted that even with the bank C&I growth over the past year - with the increase actually showing up on bank balance sheets beginning in August 2004 - the large banks are still adding to their mortgage portfolios. However, analysts said that the numbers are concealing the real story - Bank of America has the lion's share of this increase across all banks in 2004 to 2005.
Kevin Jackson, vice president at RBC Dain Rauscher, said, "It has appeared over the past one-and-a-half years that banks have demanded MBS in size versus business and other loans. It appears that treating banks as a homogeneous entity is not exactly correct." Jackson noted that in 2004, commercial banks increased their MBS holdings by roughly $100 billion and by $37 billion in 1Q05, adding that the bulk of the gain in the past year and in the first quarter could be attributed to BofA. While most banks have reduced their MBS holdings, Jackson said BofA has increased its funding share through Federal Reserve funds and repos, using derivatives to hedge risk. This is in place of funding MBS purchases in light of strong deposit growth as well as weak loan demand.
In a recent report, Bear Stearns said that as early as 2004, BofA's $112 billion mortgage growth (numbers are according to Federal Deposit Insurance Corp. and BofA SEC filings) is equal to 81% of the total mortgage growth reported by the Fed at all large commercial banks. "It should be noted that other large banks may have added to their mortgage portfolio in the past year, but, as a whole, total exposure at banks outside of Bank of America has been relatively flat," Bear analysts said. They added that the growth in MBS held at BofA seems likely to continue, citing BofA's 10-Q for 1Q05 disclosing $26.2 billion net forward mortgage commitments as far out as July, which is repeating a pattern that started in 3Q03. BofA has been regularly disclosing net forward positions ranging from $17 billion to $57 billion each quarter, added Bear. BofA's significant appetite for mortgages has played an important role. "If that appetite declined, the fallout for mortgage spreads could be significant," Bear analysts reported.
Deposit growth versus leverage
Another issue that analysts have been debating is whether deposit growth or bank leverage would be the correct indicator for bank demand.
Recently, Lehman Brothers asserted that over the next two to three quarters, banks would probably have a reduced net interest margin due to short-term rates rising. This could mean increased bank leverage to maintain earnings, benefiting the mortgage market as net bank mortgage purchases are expected to be strong as a result. Meanwhile, UBS argued that deposit levels play a far more significant role in the short- to intermediate- term in regards to forming bank investment strategies versus bank leverage trends. Analysts reiterated that structural changes in the financial system have changed the significance of C&I lending to large banks. Going forward, C&I loans are expected to take away less from securities in general, and MBS and other mortgage-related assets in particular. Deposit growth has been the main contributor to the increase in commercial banks' mortgage-related assets, UBS analysts argued.
David Montano, head of mortgage research at JPMorgan Securities, believes that deposit data is relevant but it is also important to keep in mind that "it is very volatile but generally always trends higher - bank deposits are not a leading indicator," Montano said, adding that banks do not necessarily buy MBS because there is a short-term increase in deposits. He also noted that banks have been through a phase of very heavy deposit growth that is likely to stabilize.
Meanwhile, Montano said C&I loan demand is more telling as to the changes in economic conditions, noting that this year there has been bank C&I activity growth for the first time since 2000. The impact on MBS demand will depend on whether this pattern continues. So far, net bank MBS portfolio growth has been increasingly limited to a small handful of institutions.
"Leverage is important because asset size plus C&I activity is what will drive MBS activity," Montano said. Asset size is a function of both deposits and leverage. The latter is supposed to decrease when the Fed is tightening, although it often has short-term increases as investors seek to maintain earnings. "So far bank MBS activity has been below last year's levels (for Q1); if the Fed continues to tighten and the curve to flatten, I would expect that bank MBS activity will decline," Montano said.
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