With a curve flattening on the horizon, the MBS market is gearing up for a potential shift in bank demand. A large liquidation of bank portfolios would cause a significant cheapening of mortgages. On the other hand, if bank demand remains strong, analysts forecast a considerable tightening of mortgage spreads from current levels, as the sector now appears cheap.
Street analysts have diverging views on the issue. Some predict a heavy liquidation of bank mortgage portfolios while others expect aggressive buying of mortgages because of the lack of demand for C&I loans.
"Our MBS research team has been maintaining a bearish view on the continued strong bank demand for mortgages, but we do not agree with either of the two extreme scenarios," wrote analysts from Banc of America Securities.
BofA takes a historical standpoint. In 2002 and 2003, researchers pointed out that the net residential mortgage investments (including MBS and mortgage loans) of U.S. domestically chartered banks reached roughly $280 for mortgage loans and $200 billion for mortgage-backeds. In comparison, residential mortgage debt outstanding rose by $750 billion in 2002 as well as $650 billion in the initial three quarters of 2003 -banks were taking in roughly 30% of net mortgage issuance. As of last April 21, net mortgage investments by domestic banks reached $167 billion. MBS comprised $100 billion of this figure, while the rest was made up of residential mortgages. BofA said that these numbers are for "net purchases" and do not include reinvestment of mortgage paydowns received by banks. They make up only the net additions of mortgages to bank portfolios.
"If we assume that net mortgage investments by banks in 2004 will be equal to those of 2003, which we believe is a somewhat aggressive scenario, banks are unlikely to grow their mortgages at the same pace as they did in 1Q 2004," wrote analysts from BofA.
In a separate report, Morgan Stanley stated that investors are concerned that a flattening curve will lead banks to turn their backs on mortgages like they did last summer. During the June to September period, MBS holdings significantly dipped by $71 billion from the $774 billion level.
It should be noted that payoffs during that period were running at close to 5% per month, Morgan Stanley said. Even without banks reinvesting paydowns, their portfolios should have decreased by $114 billion. Furthermore, real estate loan portfolios jumped up $102 billion over the same period, which is unusual. This would imply that banks partially substituted securities with loans. Currently, runoffs are relatively lower, with the Mortgage Bankers Association (MBA) Application Index now averaging 814 in the last four weeks, compared to 2.116 in the three-month period ending June 2003. At 40% of 2003's activity, Morgan Stanley said that runoffs will probably not exceed $17 billion per month.
BofA believes the liquidation of bank mortgage portfolios is highly improbable. First, banks usually buy close-to-par mortgages. Because the current-coupon mortgage is now close to the highest level in the past two years, most securities in bank mortgage portfolios are probably trading at prices less than their original purchase price. If banks do not sell these mortgages and keep them in held-to-maturity or available-for-sale accounts, the losses will be reflected on their balance sheets and not on their income statement.
Also, many of the bigger banks, whose mortgage portfolios have grown recently, take on duration risk by hedging through the swaps/Treasury market. These banks appear to be hedging rather actively. This is why researchers from BofA think that banks should not be significantly hurt if rates move up slowly (which is expected by the firm's economists). Because of the steep yield curve and the good carry in the sector, banks will probably pay fixed on swaps rather than sell mortgages to lessen their duration exposure. BofA also notes that banks will probably turn their back on mortgages gradually, mentioning that C&I loan demand will probably remain "anemic" for some time even though the economy continues expanding rapidly. Aside from this, there is usually a lag of several quarters between the actual C&I demand pickup and the drop in bank demand for mortgages, wrote analysts.
"For these reasons, we believe that banks will continue to reinvest paydowns on mortgages back in mortgages even though they are unlikely to add to their mortgage portfolios at the same pace as they have thus far this year," said researchers.
In the longer term, even if total real estate portfolios grow more slowly in the coming months from the current 8%, it is highly unlikely that this will dip to less than the 4.5% rate seen in the sharp 1994 back-up. "This is especially true today since, as the corporate bond market has disintermediated bank lending to the corporate sector, much of the growth in bank assets must come from real estate portfolio growth," Morgan Stanley researchers said. C&I loans now comprise 11% of commercial bank assets versus 19% to 20% in the early 1990s. They added that for as long as the housing market stays strong, banks will remain active players.
If banks do step away in the short term, this would be limited - about 40% of last year's activity - due to less prepays. Morgan Stanley expects that banks will continue growing their real estate portfolios more moderately at 4.5% to 5%. This is appropriate given the more moderate home purchase activity.
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