The recent increase in C&I lending, along with a rise in bank holdings, is once again highlighting the issue of bank demand in the MBS market. Moreover, analysts said they still expect bank demand to remain moderate going forward.

In January, C&I holdings increased by $8 billion, noted Deutsche Bank Securities. Additionally, Deutsche Bank's equity analysts anticipate that bank C&I will continue rising as these institutions search for more revenue sources and as the economy improves.

In a recent report, Lehman Brothers noted that after 13 consecutive quarters of negative growth, C&I loan portfolios have risen by $60 billion in the past three quarters. Lehman said that this does not spell the end of bank demand for mortgages.

For one, analysts report that the main factor driving bank mortgage appetite would be deposit growth and not C&I lending, noting that the relevance of C&I portfolios has dropped considerably in recent years. As early as the end of 1999, the total size of C&I loan portfolios stayed comparable to total mortgage loan and MBS holdings. However, since then, mortgage holdings have increased significantly while C&I loan holdings have diminished notably.

"As a result, the substitution effect', i.e., substituting mortgages with C&I loans and vice versa doesn't quite work anymore," Lehman analysts wrote, noting that to offset a 1% drop in mortgage holdings, C&I portfolios would need to increase by more than double that rate. Overall, analysts said that there would be a limited effect on mortgage holdings should C&I loan portfolios increase 5% to 6% in 2005.

Lehman suggests investors use deposit growth trends as indicators of future bank demand for MBS. With robust deposit growth in the past few quarters - topping 10% in 2004 - analysts expect banks to remain active in the mortgage market.

The major risk in these circumstances is if deposit growth slows considerably, bank appetite for mortgages will become muted. However, analysts do not believe banks will actively liquidate portfolios in this scenario since banks have considerably de-levered their balance sheets over the recent Fed cycle and currently have a very good capital cushion, added Lehman. Should the need arise to make room on their balance sheets for new C&I loans, these institutions could always raise their leverage to 1990 era levels. This would suffice if re-leveraging were combined with expected paydowns on existing mortgage holdings, said analysts.

Lehman also notes that bank demand would be focused on hybrids and 15-year passthroughs, a trend that began in the second quarter of last year. In 2004, bank 30-year passthrough holdings decreased dramatically - by over $100 billion - with half funneling into hybrids and the rest to 15-year collateral (see chart). Although Lehman, does not expect a similar reduction in 30-year passthrough holdings this year, analysts predict that mortgage purchases in the near term will be focused in 15-years and hybrids, favoring these sectors over 30-years although warning investors to hedge curve exposure.

Aside from this, other analysts noted that bank passthrough holdings remain robust. In a recent report, the Federal Reserve disclosed that large commercial bank passthrough holdings have risen by $30 billion. Bear Stearns added that this figure ties up nicely with trading positions announced by Bank of America last November. Bear Stearns cited BofA's 10-Q Securities and Exchange Commission filing that reported a $29.8 billion net long MBS position scheduled to settle in January. According to Bear, this coincides with the Fed data showing a jump in MBS around the TBA settlement date in January.

A similar pattern was seen in the fall of 2003 when BofA in its 10-Q filing disclosed a $49.3 billion forward MBS position that was scheduled to settle the following February. True enough, the following February saw large bank passthrough holdings jump by $64 billion, majority of which went to BofA, added Bear Stearns.

Copyright 2005 Thomson Media Inc. All Rights Reserved.

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