There  was a  $51.4 billion increase in the agency MBS holdings of large commercial banks in the past two weeks, the largest jump in 18 months, according to the latest survey data from the Federal Reserve.

This could indicate a strong return of the bank bid for agency MBS , according to a research note today by Barclays Capital analysts.  

Since  banks have typically been one of the biggest buyers of MBS and have the potential to absorb an additional $150 billion of agency mortgages, such a return could bode very well for the basis, analysts  said .

At the beginning of the year, Barclays analysts expected banks to add agency MBS aggressively in 2010. They based this expectation on historical patterns that banks tend to add to securities portfolios at the expense of loans at the end of recessions  as a result of a reduced appetite for credit risk, capital concerns, and tighter underwriting. 

Each of these factors argues for an increase of high-grade securities at the expense of whole loans, Barclays analysts said. Additionally, a steep yield curve makes fixed-rate spread products like agency MBS more attractive than floating-rate assets such as C&I loans.

Agency MBS made up about half of the securities bought by banks during past recessions, and analysts expected this trend to repeat in 2010.

Coming out of the recession, banks have again pared down their loan holdings while bolstering their securities portfolios. However, until two weeks ago, “the increase in securities had failed to translate into MBS demand,” Barclays analysts  said. 

From the start of the year to mid-July, banks actually decreased their agency MBS  holdings while adding government securities. Although some of the government bond buying was being driven by regulatory changes, banks were also investing in short-duration agency and Treasury securities, a strategy that seems to be at odds with a steep yield curve, the Barclays report suggested.

Barclays analysts stated that banks have probably refrained from investing in MBS  because of expectations that the end of the Federal Reserve’s MBS purchase program and a recovering economy could push yields higher and MBS spreads wider. 

As a result, banks had taken the defensive strategy of buying Treasurys and short-duration cash substitutes while avoiding MBS, hoping to add them later at higher yields and wider spreads.

As yields have trended lower and mortgage spreads  have continued to tighten since the start of the year, these expectations have failed to materialize. With a stronger belief that rates will stay low for an extended period of time and the lack of supply will keep MBS spreads tight in the future, banks have found it more and more expensive to stay in cash substitutes. 

These factors, along with a continued strong growth in deposits and substantial yield pickup in MBS versus Treasuries, has most likely driven some banks to “throw in the towel on the waiting game and start adding MBS,” Barclays analysts  said.

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