The 30-year FNMA and Gold 5s have in recent months seen a severe squeeze, causing the coupons to significantly richen and resulting in a considerable dislocation in the TBA roll. As of late last week, the fate of the July and August rolls remained uncertain, with buysiders waiting for Friday's release of Federal Reserve data on June bank purchases that would disclose whether dealers are controlling the coupon or not.
According to analysts, the squeeze could have been caused by the imbalance in dealer and investor passthrough trading positions, specifically in light of the significant creation of Fannie Mae Mega and Freddie Mac Giant pools. Concerns have been raised about the concentration of these pools in certain institutions, causing the persistence of the squeeze. This could have a lasting effect on the MBS market's liquidity and pricing, as well as introduce volatility in the sector, analysts theorized.
"The persistence of the squeeze would diminish liquidity - it already has," said David Montano, head of mortgage research at JPMorgan Securities. "If bank holdings do not increase, I would expect the coupon to underperform sharply as dealers cannot maintain the squeeze."
He added that this is a serious situation because the magnitude of Mega and Giant issuance this year is unprecedented, raising important concerns about excessive market share concentration in large institutions, thus leading to price and liquidity distortions. "In the Treasury market, a single investor may not purchase more than 35% of any auction," explained Montano. In direct contrast, there are currently no restrictions on the amount of purchases made by institutions in the mortgage market.
In a report released last Tuesday, RBS Greenwich Capital analysts noted the emergence of large bank and non-domestic investors in Gold and FNMA 5s. Analysts stated that Freddie Mac's marketing campaign with mortgage investors seems to have paid off with June likely to have the largest single month's amount of Giant production in a single coupon - equivalent to $20 billion in Gold 5s when preliminary Freddie numbers are included.
Countrywide Securities said that the months-old squeeze in 30-year 5s resulted from the significant U.S. bank and overseas investor demand. "While it is difficult to predict these investors' moves going forward, it is possible that the MBS market is in the midst of a major shift in asset allocation behavior - literally, of global proportions - that will permanently alter MBS valuations and liquidity," Countrywide analysts wrote.
This demand, analysts said, has contributed to the considerable MBS tightening over the last few months, adding that the combination of several factors - large bank and overseas demand, low interest rate volatility and benign prepays - could cause extremely tight MBS spreads that are well within today's levels. Additionally, given the sheer size of capital that these entities control, their asset allocation decisions could now drive market movements and dislocations. This could, in turn, push yield spreads and OASs to uncharted territory, leading to a market driven by technical factors, rather than relative value and causing increased pricing volatility.
Other analysts said that, in the past, when the GSEs were significant buyers, the agencies were conscious of their mandate to help keep the MBS market orderly. By contrast, overseas buyers - mostly foreign central banks - are not obliged to maintain market stability and liquidity. Additionally, the main motivations would be to buy bonds at or slightly under par as well as to make the most liquid purchases possible. In other words, they are not driven by performance or relative value constraints, as other investors would be.
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