With the economy picking up and the Federal Reserve expected to change its bias, bank movement from mortgages to traditional business lending could cause considerable underperformance in MBS.
When this happens, there's usually a negative correlation between banks' MBS holdings and commercial loans. As described in research from Countrywide Securities last week, this negative correlation is caused by the increase in Commercial and Industrial (C&I) loan demand and the decrease in the attractiveness of MBS via Fed tightening.
Countrywide looked at whether the correlation means a "direct substitution" by banks of one asset class over another. The firm also looked at whether this will cause considerable mortgage underperformance considering the other powerful influences on mortgages, including prepayments, volatility, the state of other competing asset classes, and GSE behavior.
The Fed tightening will definitely lessen the banks' spread over funding for new MBS purchases, Countrywide said. Aside from this, forward rates are also projecting that, two years from now, the yield curve between 12-month Libor and the five- and 10-year swap rate blend will be flatter by roughly 150 basis points. Meanwhile, there are also strong signs that business loan demand is rising. Analysts noted that banks are reporting rises in business loan demand for the first time since 2000, which is similar to what happened in the 1992 to 1994 recovery period.
"The lags can be quite long and the degree of change uncertain, but there can be little doubt that a shift in bank assets is coming," wrote analysts. "How the shift affects mortgage market performance from here is the vital question for investors." Countrywide looked at MBS pricing in a longer-term historical perspective. According to the firm, tightening periods in 1999, 2002 and 2004 usually happened during the scale-down from major refinancing peaks. This MBS widening-and-tightening pattern following refinancing waves makes it hard to pin down a consistent statistical relationship between mortgage performance and the slope of the curve. But, all other things being equal, a steeper curve is good for valuations. However, a big refinancing event historically includes both a steepening of the curve and a period of MBS underperformance. The increase in mortgage rates that results in a reduction in refinancing volume usually comes along with a flatter curve and tighter spreads on mortgage-backeds.
Is the market ready?
"In the context of the current situation, we believe investors should focus on the extended period of above-trend MBS yield spreads that ran from 1994 through early 1997," wrote analysts. "Of course, history cannot be counted on to repeat itself, and a closer look at the 1994 experience also brings to light some important differences from the current environment." The first is the market's current preparedness for the tightening. With the Fed meeting on Wednesday, when the first increase in the target Fed Funds rate is expected, the 30-year current coupon yield stands at 155 basis points over last June's cycle low. Comparatively, on the day before the first tightening in February 1994, the 30-year current coupon was only 16 basis points over its lows from the prior October - which demonstrates a lack of preparedness during the 1994 cycle. Analysts said this lack of foresight probably contributed to the sector's underperformance.
In contrast, after coming down from refi waves in the beginning of 1999, early 2002 and thus far in 2004, the MBS sector has responded by trading considerably well, with spreads in each case moving below trend. Analysts said that 1999 and 2004 had a fairly orderly runup to Fed tightening in that the central bank's moves were telegraphed and priced into the market well in advance. In the current selloff, movements to cheaper levels have coincided with breakouts to new cycle highs in yields.
Even with the sector's current richness, the longer-term outlook for MBS isn't clear. Though there are positives for MBS in an extended bear market, there are also some serious negatives. A shift in bank demand remains a concern as the last time C&I lending rose, mortgages cheapened and stayed cheap for three years. Minus the bank bid, the CMO market must depend on different constituencies, such as insurance companies. Analysts also noted that the GSEs will likely have slower balance sheet growth and that the curve will probably flatten, adversely affecting mortgage OASs.
"In the near term - the next three to six months - we expect a continuation of the Spring 2004 trade, in which MBS are very well bid and spend most of the time on the rich side, only undergoing serious short-term widenings in breakouts to new rate highs," said analysts.
Longer term, Countrywide is concerned that the reallocation of bank assets will pressure mortgage spreads wider. Though researchers don't expect a wholesale shedding of mortgages, banks will probably be unwilling to replace runoff as business lending picks up. "The catalyst to wider spreads might well be an exogenous event," wrote analysts. "The effect of the banks is more likely to be in what they don't do - the lack of a bank bid to pull the sector tighter when it cheapens."
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