Conditions in the U.S. mortgage backed securities market have improved, but the market still has a ways to go before it regains its pre-financial crisis vigor.
That said, commercial banks have been buyers of agency mortgage bonds. The better demand is evident not just in passthroughs but also in CMOS and PACs.
At the same time, the Federal Reserve's buying program has helped steady a market that last year was rocked by historically wide yield premiums and a severe drop in liquidity.
The Fed in late December announced that it will begin buying MBS in early January. It selected private investment managers - BlackRock, Goldman Sachs Asset Management, PIMCO and Wellington Management Co. - to act as its agents in implementing the program that has the nation's central bank buying MBS backed by loans with guarantees from Fannie Mae, Freddie Mac and Ginnie Mae.
Spreads of passthroughs were at roughly 195 basis points to the U.S. Treasury curve last week. According to Art Frank, head of mortgage research at Deutsche Bank Securities, "we have been under 200 since the Fed started buying. Our outlook [on mortgage bonds] is neutral. We'd be negative if the Fed were not involved," Frank said.
"Of the government programs that have actually taken action and have worked the best, the best example is the agency mortgage [market]," said Andrew Harding, portfolio manager at Allegiant Asset Management Co. "It has brought a great deal of clarity to the marketplace. The market needs clarity more than anything else."
Only fixed-rate agency MBS securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae are eligible assets for the program. The program includes, but is not limited to, 30-year, 20-year and 15-year securities. It does not include CMOs, REMICs, Trust IOs and Trust POs, as well as other mortgage derivatives or cash equivalents. Eligible assets may be purchased or sold in specified pools, in to be announced (TBA) transactions and in the dollar roll market.
Some investors, meanwhile, never really abandoned the agency mortgage market.
Tad Rivelle, chief investment officer of Metropolitan West Asset Management, which manages $26 billion, said his firm purchased agency MBS at the time news of Bear Stearns' problems was roiling the credit markets. Back then, spreads of agency mortgage passthroughs hit 250 basis points to the U.S. Treasury curve, and they returned to those levels in November.
Before the credit crisis took root in 2007, spreads of agency passthroughs, on average, were at 125 basis points. They narrowed to 100 basis points at the height of the credit boon.
"We've been constructive on agency mortgages. If spreads ratchet in ... we would pare some back," Rivelle said.
As Rivelle sees it, "U.S. investors are more accepting of the idea that the U.S. government is not going to walk away from Freddie and Fannie debt or guaranteed mortgages."
While structured mortgage bonds are not in the Fed's buying program, there has been an improvement in liquidity within certain structured mortgage-backed products, according to investors like Harding.
Spreads of the structured products, though, remain wide and may have attracted some investors. Spreads of structured products such as five-year sequentials using 6% agency passthroughs as collateral are at 300 basis points to the U.S. Treasury curve. That is out from roughly 120 basis points prior to the credit crisis.
Meanwhile, two-year PACs are at 245 basis points to the curve, and five-year PACs are at 275 basis points to the U.S. Treasury curve. In normal market conditions, two-year PACs were at 70 to 75 basis points to the curve, and five-year PACs were at 90 to 100 basis points to the curve.
Those wide spread levels for structured mortgage bonds have attracted smaller banks in search of added yield, say market participants.
"Smaller banks are buying CMOs and agency ARMs," Frank said.
What has aided that bid for structured products from banks is a steeper U.S. Treasury yield curve and a drop in commercial and industrial loans, according to the Deutsche Bank market analyst.
The steeper curve allows for banks to engage in the carry trade - that is, borrow on the short end and invest in longer dated securities.
A recent report published by Barclays Capital analysts noted that in 4Q08, there was a rise in bank holdings of mortgage securities. Some of the biggest increases in holdings were at Bank of America, JPMorgan Chase, Wells Fargo, Citigroup and PNC Financial Services.
Barclays market analysts found that the top 50 banks added $109 billion worth of MBS to their portfolios. Of this, $96 billion was in agency MBS.
Buying by the large banks could cool off, according to participa nts. Indeed, some of that massive gain in fourth-quarter holdings may have been tied more to a series of mergers within the industry. Barclays analysts estimate in their report that about half of the increase in agency MBS holdings in the fourth quarter was a result of two acquisitions.
Meanwhile, market participants pointed out that liquidity in the mortgage bond market has improved, but there is a marked change in who is buying and how. The number of trades and participants is down from a year ago, but the dollar volume of the bonds is still roughly the same.
Notably, investors that relied on leverage such as hedge funds are less of a presence in the market, and there is less buying by insurers.
"The volume is the same. There are fewer but bigger trades happening," said Frank, adding that "[loan] originators are selling in size, and the Fed buys in size."
But how long investors can count on the Fed is uncertain. The program lasts until mid-year. The agency MBS program will involve the outright purchases of up to $500 billion in agency MBS by the investment managers on behalf of the Federal Reserve by the end of the second quarter of 2009, according to the central bank.
In the meantime, the improved mortgage debt market conditions have helped bring U.S. mortgages lower - 30-year rates tracked by Freddie Mac have ranged between 4.96% and 5.25% in first couple of months of 2009 - but they have failed to stir up borrower interest on a large scale.
Last week, the National Association of Realtors announced that existing home sales fell 5.3% to a seasonally adjusted rate of 4.49 million units. Not only were prices down 14.8% from levels a year ago, the pace of sales hit levels not seen since 1997, and distressed properties accounted for 45% of the sales.
Economists had been expecting a slight rise in sales of existing homes.
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