With bank demand not as aggressive compared to last year, analysts are questioning whether the carry trade could be as compelling as it had been in the past, and have concluded that bank demand for mortgages would probably not return to the lofty levels of 2003.
In a recent report, Lehman Brothers said that if Treasury yields settle in a range at current levels, the closest benchmark would be the first quarter of last year when 10-year Treasurys were trading at roughly 4%. During that period, the carry trade was the major theme in the mortgage market. Mortgages had a significant run as bank demand was considerable, said analysts. Additionally, the CMO machine was active and the TBA market offered near zero financing.
Lehman examined whether the same factors are still in place today. The key to this question, analysts said, is whether bank demand will pick up from recently depressed levels. This depends on institutions' needs and desires to buy mortgages, analysts said.
In terms of demand, there have not been that many changes in terms of banks. Lehman said that deposit growth remains explosive, averaging 10% annualized in the last five months. There have not been a lot of changes on the C/I loan front as well. Although the rate of decline in C/I loan portfolios has stagnated, there are still no signs of growth. Despite the fair amount of the deposit growth that have been channeled towards mortgage loans and securities, banks are still delevering their overall balance sheet. This is merely a temporary solution as the need to buy assets remains strong for commercial banks.
Lehman said that the reason for bank reluctance to add assets aggressively is mainly due to the Federal Reserve. With the Fed in a tightening cycle, banks have understandably been cautious in adding duration in recent months. The question is whether this would change if the markets get comfortable with sustained lower rates.
There are three reasons why analysts think bank appetite for mortgages will not reach the same levels as early 2003. The first being that since March 2003, the yield curve has flattened significantly with the 2s/5s spreads coming in by over 50 basis points. Furthermore, nominal spreads on mortgages have tightened even more due to the secular drop in implied volatility. Banks seeking incremental spread by selling convexity through mortgages are paid 40 basis points less today than 19 months ago. Lastly, the gains in banks' securities portfolio are significantly lower compared with March 2003, when rates were at similar levels. The average coupon on bank portfolios dropped significantly with the refinancing wave last year. Analysts estimate that current gains in AFS portfolios are less than $4 billion. At the peak of the carry trade, this number was more than $12 billion. Limited cushion in securities portfolio will make banks more reluctant to add duration aggressively in the current environment, analysts explained.
The other aspect of last year's carry trade was the financing advantage of TBA passthroughs. Apart from demand for securities in the front month, dollar rolls also benefit from strong supply in the back months. With rates comparable to levels seen in the first quarter of last year, Lehman questioned whether it was reasonable to expect gross monthly issuance to reach similar levels.
The answer is, unfortunately, no. The average WAC of the fixed-rate mortgage universe has dropped by more than 75 basis points over this time period. Because of this, at current levels, monthly gross issuance in mortgages will be significantly lower. While that puts a damper on investors banking on the roll market, the positive is on the mortgage convexity front. Origination pipelines were the biggest source of convexity risk last year. Given their limited size today, researchers are not expecting to see any strong convexity hedging related flows.
Other analysts said that the carry trade never went away. "There are still many banks that are buying bonds despite the fact that funding rates have risen 75 basis points," said an MBS analyst. " From the point of view of investors, there is still some decent spread out there." For instance, he said that 15-year 4.5s are yielding approximately 4.5% while funding costs are in the area of 1.88% to 2%. Additionally, he noted that FNMA 6s for October settlement was funding at a zero cost of funds in the beginning of August in the roll market, and are still rolling at least 100 basis points special. The strength of demand for carry vehicles, "all depends on whether investors are comfortable with a steady and relatively nonaggressive Fed, " said the analyst.
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