Banks have been retreating from buying MBS at current yield levels, affecting CMO demand. Analysts predict that these financial institutions will soon be buying mortgage-backeds again, though CMO creation might wait a little before it catches on again.
In a recent UBS Warburg report, analysts said that, judging from discussions with banks, only a few were reinvesting their runoff in MBS. Meanwhile, many of these banks were outright sellers of MBS and/or holding a large share of their mortgage production in non-securitized form. UBS noted that, according to Federal Reserve numbers, holdings of MBS by large commercial banks plummeted to $317 billion (9/17/2003) from $389 billion (6/25/2003), which is a huge $72 billion plunge equivalent to 18.5% of total holdings.
This reticence on the part of the banks is a relatively recent phenomenon. Banks actually remained active in the mortgage market through June 2003 even as interest rates were bottoming out, said a Lehman Brothers report released last week. The report stated that large domestically chartered commercial banks added to their MBS holdings by 9%, increasing to $437 billion in June from $401 billion in April. Their whole loan holdings rose by $45 billion during the same time period.
However, interest rate volatility reduced bank demand in July and August, Lehman said. Mortgage purchase volume also dropped. In fact, MBS purchases were negative during this period.
Lehman thinks this dropoff in investment is merely temporary. The firm also believes that there will be a resurgence of mortgage investment by banks in the coming months.
The firm cited the fact that banks can add assets without adversely affecting leverage. Analysts estimated that Tier 1 capital ratio for the median large domestic commercial bank rose to 8.38 in the second quarter from 8.12 a year ago. Based on their current balance sheet position, these financial institutions can add $116 billion in assets to restore leverage to 2002's levels.
And even if banks do not add $116 billion of assets as Lehman has estimated, even half this figure would be a considerable source of demand, analysts said. To put this in perspective, Lehman predicts that with cash-out refinancing fading away, net issuance of all mortgages should be in the $40 billion to $50 billion per month range. The report said that, "$116 billion deployed over the next quarter, or even half of that would be a significant part of net mortgage issuance, and a positive for the mortgage basis."
Analysts also expect bank demand for MBS to come back due to the lack of investment alternatives, specifically for C&I loans. Both Lehman and UBS agreed there is currently no significant C&I loan demand.
The UBS report said that C&I loans at large commercial banks have now dropped to $451 billion from $472 billion in early July. Lehman believes that C&I loan demand would not rebound next quarter. Additionally, mortgages have offered wider spreads, making them more attractive than bank funding over the last few months, specifically versus a year ago.
Aside from this, UBS gave other reasons why bank demand will come back despite the banks becoming net sellers of mortgages in recent times, all pointing to the fact that these financial institutions will need to make use of their money.
One factor is bank deposits have increased considerably. Deposits have been up $50 billion since June. With funding at 1%, banks need to reinvest extra capital. Also, banks will receive prepayments in early October. "And even though we expect sharp speed slowdowns, we expect that banks will be forced into the market to reinvest those prepayments, as they are already awash with cash," analysts wrote.
One concern that Lehman raised is that recent losses on MBS positions could have impaired bank appetite for mortgages. However, the firm noted that with the par-coupon yield close to where it was before the rally in May, only the April, May and June purchases are materially under water.
Utilizing very conservative assumptions, Lehman predicts losses of no more than 2.5% on the gross $100 billion purchases, totaling $2.5 billion. This loss would amount to less than 1% of the total Tier 1 capital of the large commercial banks (about $313 billion). Furthermore, this is swamped by the $35 billion increase in capital over the last year.
The UBS report said that agency CMO creation for September was the lightest one in two years. What makes the situation worse is that the plunge in CMO issuance happened as considerable mortgage production remains. This made the percentage of CMO absorption of mortgage production considerably low at 17.6%. Also, September 2003 was the only month in the past two years in which CMO absorption of new production was less than 25%.
Analysts said that because of this lack of CMO issuance, Golds are currently quite cheap. Aside from this, in the non-Agencies, 30-year fixed product is currently trading mostly in pass-through form, with the bank bid for short paper now missing and making it hard to "carve this paper up," wrote analysts. They added that non-Agency hybrids have cheapened significantly to Agency hybrids.
Despite the dearth of CMO issuance, analysts say that CMO creation is going to come back, though not as it has in past years.
Researchers at Citigroup Global Markets believe that while C&I lending has dropped consistently from the start of 2001, the curve has remained quite steep, serving as a benefit to pass-through and CMO valuations as well as attracting banks to these sectors.
"The same factors that should induce banks to increase pass-through purchases in the fourth quarter should bolster CMO demand," said Citi in a recent report. But bank participation in CMOs is probably going to be on a smaller scale compared to the one the market saw prior to the summer selloff. Slower prepays suggest banks have less need to reinvest the mortgage paydowns. This is why there will be less bank participation going forward, given the absence of another sustained rally.
Meanwhile, UBS said that banks would probably re-enter the MBS market in early October. But it is not yet clear if the CMO bid will resume right away, with mortgages very tight and dollar prices quite high.