The supply/demand technicals in the MBS market currently appear to be relatively stable.
For the year, estimates for net issuance range between $500 billion and $600 billion, or approximately $50 billion per month. Based on the outlook for demand from the GSEs, banks and mutual funds, a good portion of the supply should be readily absorbed.
Agency MBS are becoming increasingly attractive for the GSEs, said Lehman Brothers analysts in a recent report. The instigator has been strong demand for short paper - especially agency debt - given all the market uncertainty. This has caused spreads to tighten substantially in short agencies.
To illustrate, analysts noted that six-month agency paper has tightened over 40 basis points from a year ago and is trading through Libor. At current TBA valuations, Lehman analysts calculated that the agencies can generate returns of 20% to 30% based on the cheap financing levels. While funding assets using only short-term funding is risky, Lehman analysts believe the strong growth in money manager funds - which is currently running at about $400 billion per quarter, a four-fold increase from a year ago - has made this a less risky strategy for the agencies.
Given the easing in GSE capital surplus requirements, Lehman analysts estimated that the agencies can increase their portfolios by as much as $160 billion to $200 billion over the next year.
Aside from the agencies, bank demand for MBS has been very strong this year.
According to a report from JPMorgan Securities, bank MBS holdings have risen by $90 billion in the first five months of this year. The gains have come largely from declines in residential loan holdings - down some $60 billion so far this year, analysts said. This was attributed to the weak housing market and tighter underwriting.
JPMorgan analysts are less certain about the demand as banks could determine if it is better for them to de-lever while maintaining conservative growth expectations. Analysts noted that Citigroup has indicated it expects to shed around $400 billion in assets, primarily mortgage-related and CDOs, over the next three years.
Also likely to affect banks' buying of MBS is some weakening in NIMs and prospect of Federal Reserve tightening down the road. Still, JPMorgan analysts said that margins currently remain attractive and the lower funding could support demand for some time.
JPMorgan analysts also looked at mutual fund demand for MBS. They noted that their sample of 20 large MBS funds bought $6 billion in MBS in April and May, following the improved liquidity and tone of the market on the Fed's aggressive initiatives.
"If this trend continues, we could see fund flows drive $15 billion to $20 billion of MBS demand," the analysts said.
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