There was considerable talk last week about the presence of the GSEs on the bid for 10-year notes. The agencies have been a conspicuous participant in buying mortgages of late after being relatively absent since the first quarter as they attempt to reinvest the paydown proceeds of the mortgages that they hold. Buying in MBS both periods prompted a hedge in Treasurys, made all the more prevalent with the latest rally.
Fannie Mae reported last week that their mortgage portfolio grew at a 4.6% annual rate in July. This compares to just over an average 16.4% in the first quarter and 5% for the second quarter. At the beginning of the year, Fannie estimated a 16% growth target, following a comparable increase in 2001, but the spread tightening that occurred between MBS and agency debentures limited the amount of buying done by the GSE. Fannie has since re-estimated growth this year in the mid-to-low teens.
Despite the slower growth in recent months, there is some notion that it will pick up in coming months. So far, 2002 portfolio growth has been 9.5%, far below even their conservative estimates. In addition, mortgages are cheapening versus debentures on a volatility-adjusted basis in the midst of a curve rally and subsequent convexity pressure. There has also been plenty of talk from traders over the last week of GSE's returning to the bid.
Another interesting note about the Fannie report was that its duration gap - a measure by which the agency tries to balance assets and liabilities - fell outside of their target six-month range. For July the gap widened to -9 months as a result of the prepayments and paydowns seen during the lower-rate market environment, down from -4 months in June. This suggests that Fannie would be in the market picking up paper to both put the cash infusions to work as well as to increase the duration of its portfolio by purchasing new vintage MBS.
Buying newer vintages
The idea that yields and mortgage rates are at the lows of the year - hopefully - boosts the suggestion to buy newer vintage paper. As rates head higher, durations will start extending and lift the duration gap as well. Given the levels of prepayments as measured by the Mortgage Bankers Association (MBA), analysts from Salomon Smith Barney suggest that 2001-vintage prepayments will increase by 60% to 70% in the coming months. By contrast, 2002 collateral prepaid 38% slower in July for the 5.5% through 8% coupons. Salomon analysts highlight the possible difference being that newer loans are less likely to refinance because of the costs of pursuing a refinancing so soon after origination or a previous refinancing. Salomon does admit, however, that a sustained rally in rates will mitigate any costly efforts involved in getting a new loan.
Nonetheless, a GSE presence will be felt by the market, especially in mortgages where buyers have been concerned about both losing convexity as rates rally and an extension should the market quickly reverse direction. There is some anecdotal evidence that fixed-rate supply, according to researchers from JPMorgan Securities, was only $3 billion in July, down substantially from the average $22 billion per month seen in the first six months of the year.
Now that ARM issuance is on the rise, analysts from JPMorgan estimate that if sustainable, fixed-rate issuance will stay at a $3 billion to $5 billion pace, reducing the tradable float. Even if the GSEs maintained 10% portfolio growth, this would amount to $8 billion to $9 billion in net purchases. Mortgage holders would like nothing more than for this to unfold, as spreads would tighten not only as demand outstripped supply, but also as long-dated volatility declined.