Even with the GSEs struggling with accounting issues and potential accounting regulations hitting banks, supply and demand dynamics in the MBS market have not gone haywire. In fact, MBS spreads have remained "stubbornly tight," analysts said.
In a recent report, Bear Stearns said that the likely cause of tight spreads is a lack of supply. "If current trends continue, net supply of fixed-rate MBS will be negative this year for the first time since 1990," analysts wrote. "A shrinking fixed-rate market may continue keeping spreads tight." Analysts noted last Tuesday that the LOAS on par 30-year paper is now at minus five basis points, which is three tighter than the beginning of 2004.
However, some investors believe that that the potential for the GSEs not being able to provide a cheapening backstop could negatively impact spreads despite the decreased fixed-rate supply, considering that Fannie, for instance, has bought $150 billion to 170 billion MBS in assets so far this year. "I think over the next six months to a year spreads will be impacted depending on how Fannie's situation pans out," said Bill Chepolis, a managing director in the fixed-income group at Deutsche Asset Management.
He added that the lack of a Fannie Mae backstop might also make the market more volatile. With increased potential for volatility in the market, Chepolis said that this would likely point to MBS investors being more inclined to make opportunistic basis trading of MBS versus Treasurys or swaps rather than just buy-and-hold investing. This might also lead to increased mortgage Treasury trading and investors favoring structure as a means of limiting to get better volatility duration in this environment.
Aside from reduced GSE buying, regulatory issues might hinder MBS demand as well, specifically from banks. For instance, EITF 03-1 creates some new incentives for banks to hold loans rather than securities. If the EITF guidance is applied as proposed, losses in AFS account could actually flow through to income in certain circumstances. On the other hand, loans get marked at their amortized cost, though banks usually have to hold more capital against them. Analysts said that as a consequence a lot of banks might opt to hold a larger portion of their mortgage exposure as whole loans and securitize less than they have this year.
JPMorgan Securities analysts said that although EITF 03-1 might lessen bank MBS activity, they believe overall bank mortgage holdings are unlikely to drop without a corresponding rise in C&I lending. The firm expects a lower securitization rate that will result in less supply in the fixed-rate MBS market - the dominant theme in 2004. "Consequently, we view market overreaction to the accounting controversies (which are frequently poorly understood) as potential opportunities," analysts wrote.
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