Even with the U.S, Treasury's September data showing an increase in foreign agency security investment, JPMorgan Securities analysts believe that expectations of foreign demand for MBS are highly overstated.
According to the Treasury International Capital data, net agency purchases - MBS and agency debentures combined - were at $15.5 billion in September, increasing from $10.9 billion in August. Specifically, Credit Suisse First Boston estimated net MBS purchases at $20.9 billion during September, rising from roughly $9 billion in August. September's MBS purchase volume is based on an estimated net $5.3 billion in Agency debt redemptions over the month, making the net MBS purchases higher than the total net agency number. Furthermore, the roughly $59 billion in net MBS purchases over the third quarter is the highest quarterly average year to date, CSFB reported. To compare, second quarter purchases were estimated at $31.7 billion while the year-to-date average is $42.7 billion.
CSFB mortgage strategist Mahesh Swaminathan said that he still expects foreign sponsorship of MBS to continue or even increase. The quarterly pace of foreign MBS purchases in 2005 is comparable to that in 2004. Swaminathan cited two reasons for this - the U.S. current account deficit and the broadening foreign investor base, now including not just central banks but more private institutions as well. The timing of these purchases, however, is "still up in the air" as foreign accounts are usually "opportunistic buyers who prefer to buy at the top of a yield range," according to Swaminathan. Currently, with the market still seeking to establish a range, foreign investors remain on the sideline although Swaminathan believes that they will eventually become meaningful MBS buyers. Despite this belief, CSFB has an underweight recommendation on the mortgage basis as analysts are concerned about the technicals with banks currently being sidelined. GSEs - though in a better position to buy - likely need at least five basis points of further OAS widening to become meaningful buyers, foreign investors are still waiting for yields to stabilize, and servicers remain potential sellers in a rate back-up. "There is also additional uncertainty as to what level the Federal Reserve would stop tightening," Swaminathan said, adding that there is still potential for increased volatility. "The market is still trading very directional with mortgages expected to do relatively okay in a rally and widen out in a sell off, " he added.
Despite rising MBS purchases, JPMorgan analysts believe that - after misgauging the extent of overseas buying - market perception seems to have moved too far the other way as overseas MBS buying expectations could now be considered vastly overstated. "There is significant data from both the Federal Reserve and U.S. Treasury on overseas MBS and agency purchases. Unfortunately, the data is frequently misrepresented or significantly misinterpreted," wrote JPMorgan analysts. For instance, Fed data on agency securities held overseas showed a significant fourfold rise, almost all going to Asia.
JPMorgan analysts did, however, add a couple of caveats to the data. For one, this represents a combination of agency debentures and agency MBS. For MBS, the data reflects the original face value and not the current factor, which could distort the MBS position. Although the Fed alerts readers to this fact, it does not adjust the calculation since MBS represents a small component of the total, JPMorgan analysts added.
Furthermore, as a percentage of total agency securities outstanding - including debentures and MBS - overseas investors have held a relatively stable share since 1999, between 11% and 14%. Therefore, while there has been an MBS purchase rise, it seems mostly due to diminished supply in agency debentures and low interest rates.
JPMorgan analysts also note that foreign investors took up the slack for the GSEs last year. Since overseas demand tends to be almost exclusively in fixed-rate agency MBS, net supply decline was a contributing factor to last year's mortgage outperformance. However, JPMorgan analysts noted that overseas MBS purchases were dominated by non-official institutions. Net central bank MBS demand has been from only a handful of countries and most official overseas security investments have been in Treasurys and agency debentures. The real MBS buying increase has come from private institutions, including banks and insurance companies, with purchases accounting for roughly $100 billion in net purchases last year.
While the 2005 purchase pace is now comparable to last year, private institutional participation is unlikely to reach 2004's levels. On the other hand, central bank activity, which has already topped the 2004 level, is expected to be its highest ever. At the margin, JPMorgan analysts said that while the $10 billion per month net overseas buying was enough to tighten mortgage spreads in 2004, this was with zero net supply and stable GSE portfolios. This buying pace has only been enough to stabilize spreads in the first half of 2005. Due to originations, JPMorgan analysts expect MBS supply to be well over $120 billion over the next six months, with bank delevering possibly adding another $100 to $200 billion. Thus, with this amount of supply, the current overseas investment pace will likely be inadequate to stabilize spreads, JPMorgan analysts summed.
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