This week’s U.S. Treasury announcement that it will be selling up to $10 billion per month of its $140 billion MBS portfolio came as a surprise to most MBS market players.
The next question after the Treasury's move, according to Bank of America Merrill Lynch analysts, is what the new source for private capital will be.
The three options, according to analysts, broadly speaking are money managers, banks and overseas investors, which should include official government institutions. Analysts reported that approximately 7.5% of the 12% of agency MBS held by overseas investors is owned by foreign governments.
The investor group poised to considerably add MBS exposure this year is REITs, analysts said.
REITs are steadily becoming an important source of levered demand for agency MBS. Analysts believe this will lead to spreads staying narrow versus historical standards in the coming months.
With spreads narrow, and technical and prepayment conditions very supportive of them remaining this way, leverage will be needed to enhance agency MBS returns, BofA Merrill analysts stated. Analysts' bullish recommendations in the IO and inverse IO space are a reflection of their view that leveraged exposure to prepayment risk should generate very attractive risk-adjusted returns this year.
The REIT “trade”, they said, is basically a variation on this recommendation. Analysts consider REITs emerging in the context of Housing Finance Reform and Secretary Tim Geithner’s announced goal to “crowd private capital” into the U.S. mortgage sector.
Data from the firm showed the cumulative equity capital raise for REITs since the start of last year. Analysts saw a pronounced rise in 2011. They estimated that, as of March 22, REITS raised just above $7 billion in 2011, compared with just $4.5 billion in the entire 2010. Assuming a conservative 5x net debt-to-equity ratio for REITs, the 2011 capital-raising will mean north of $42 billion of MBS buying power, which analysts believe is considerable.
As the government, which is the largest MBS investor, seeks to limit its presence in 2011, analysts expect that that capital raises and MBS buying will continue in the REIT sector. Analysts think this will be a stabilizer for MBS spreads and, as was witnessed over the week, buying on spread widening will continue to make sense.
Meanwhile, they said that among private investors, according to BofA Merrill researchers, banks and money managers have increased their ownership modestly in the past year, implying that there is some crowding out by the government, particularly the Federal Reserve.
However, they said that in 2011, bank MBS participation has been minimal. Analysts estimated that banks have only added $3 billion. Net supply of agency MBS, meanwhile, is already at $55 billion, they noted.
It is not really clear if capital constraints for banks are behind this limited demand, or if they are just waiting for higher yields to emerge. Despite this, analysts said that the onus is on money managers to pick up the slack on the demand side.