Fannie Mae reported an additional $20 billion decrease in its retained portfolio in August, with another dip expected for September. After this, Fannie could likely stop reducing its mortgage holdings as it is expected to exceed the capital surplus target set for Sept. 30 by the Office of Federal Housing Enterprise Oversight. This, combined with Freddie Mac's growing mortgage portfolio reported Sept. 23, is good news for the mortgage market.
Year-to-date, Fannie's retained portfolio has been reduced by $136 billion. David Montano, head of mortgage research at JPMorgan Securities, said that he believed Fannie was on target to exceed its capital surplus target last week, citing Fannie's reported retained commitments that reached an all time low of $20.9 billion. Some of these sales, however, might have settled and could reflect under both the retained commitment and the portfolio sales categories for August.
Montano predicts that Fannie's retained portfolio will drop by over $20 billion in September, suggesting that the portfolio's total reduction would be roughly $160 billion throughout the first three quarters of the year. Although this would mean that the GSE slightly went over OFHEO's capital surplus requirement, it does not suggest that there will be sufficient excess capital to considerably grow the portfolio in the fourth quarter, Montano said. "We expect simply that the retained portfolio will stabilize, potentially with increased relative value trading activity," he stated, adding that the biggest surprise was that the market was able to absorb Fannie's selling throughout the year, equivalent to $72 billion in explicit portfolio sales and $64 billion in non-reinvested paydowns. This was a consequence, Montano said, of the comparatively low net issuance in the first half of 2005 as well as considerable overseas and money manager purchases. However, similar liquidations would have a more negative effect on MBS performance in the current environment with net 30-year supply increasing at a fast pace.
Currently, this improved GSE demand picture, combined with continued overseas buying, is supporting the MBS market, despite carry slipping away. However, this could all go south with an inverted yield curve.
Bear Stearns analysts report that the yield curve flattening along with the lack of special dollar rolls have "combined to knock carry way down despite more duration and more negative convexity in most coupons today." This has spurred decreased sponsorship for agency MBS from bank and many total return investors. But with Freddie and Fannie expected to end portfolio shrinking activity, the MBS picture "doesn't look that bad," analysts stated, adding that they remain neutral on mortgage spreads.
Art Frank, head of mortgage research at Nomura Securities, noted two factors that are currently offsetting the banks diminished mortgage holdings: improved GSE demand and overseas support for the MBS market.
However, an inversion of the yield curve could cause MBS spread widening by accelerating bank mortgage portfolio shrinkage and driving increased ARM to fixed refinancing, bringing "extra fixed-rate supply to the market that could put pressure on fixed-rate spreads," Frank said. As of last Thursday, Frank stated that 2s to 10s Treasury remained at 18 basis points, a level that could still moderate bank portfolio selling but is not far from a potential curve inversion. On a positive note, he added that the most recent Federal Reserve report on bank activity indicated only a gradual slowing in banks' mortgage purchase activity.
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