Before the government announced that it would no longer sell 30-year Treasury bonds last Wednesday, MBS analysts were saying that the sector had been holding up very well despite supply issues and prepayments running at a record high.
This better-than-expected performance was attributed to MBS bank demand remaining strong, as these financial institutions continued to turn away from corporate credit and to increase their holdings in the securities market.
However, at a conference call last Thursday, analysts from Lehman Brothers said that there is uncertainty around whether bank demand would still be strong in light of the dramatic flattening of the yield curve caused by the government's move.
But even with these reservations, the analysts said they believe bank portfolios are going to continue to add mortgage exposure going forward. They cited the fact that the difference between the five-year and one-year is still about a hundred basis points steeper than it was six months ago, combined with portfolio run-offs as factors that would still fuel bank demand.
In a recent report, JPMorgan analysts said that the weak economic data as well as comments from the Fed Governors imply that the Central Bank thinks it would take time for the effects of low rates to be felt. This might also mean that the Funds rate, projected by JPMorgan to be cut by 2% by year-end, will continue to stay at low levels until better employment and sales numbers prevail.
"We believe that this will perpetuate the trend among depository institutions to boost securities holdings to add net interest income to their books during this period of sluggish loan demand," said the JPM analysts. "Coupled with demand from the agencies and CMO creation, we believe this appetite will provide support for mortgages on any widening."
Why demand is so high
According to Lehman Brothers, the total holdings by U.S.-chartered banks of mortgage securities is in the neighborhood of approximately $550 billion. And over a three-and-a-half-month period covering July, August, September and half of October of this year, their net increase of mortgage holdings is about $55 billion.
Analysts said that there are three major reasons for the increased amount in mortgage holdings among banks.
The first is the fact that since portfolio run-offs are now considerably high due to the uptick in prepayments, banks have to reinvest these paydowns somehow, thus fuelling the demand for mortgages.
And with the shape of the yield curve, banks feel that they are getting compensated by extending out the yield curve and picking up incremental spread.
Aside from these, analysts said that with the slowing economy the banks' loan portfolios are not able to grow as fast as they need them to be, prompting them to turn to the securities market to meet their ROE and growth target.
Bank demand will continue going forward as long as the economy remains as it is currently, experts said.
"Banks are likely going to stay very highly involved in the mortgage market over the near to intermediate term," said Srinivas Modukuri, mortgage strategist at Lehman Brothers. "Unless there is a sharp back-up in rates or there is a strong economic rebound, banks are going to continue to be big buyers of mortgages."
Selling optionality as opposed to going down in credit
Analysts are comparing the current scenario to the recession that occurred back in the early 1990s, when the yields on banks' portfolios and their overall earnings were very low.
In this situation, banks could either go down in credit, which usually means taking corporate or consumer credit exposure from the triple-A level down to the double-A or single-A category. Another option for these financial institutions would be to buy mortgages and sell optionality instead of going down in credit.
In a deteriorating credit environment, however, banks are much more willing to add incremental spread by selling convexity than taking on credit exposure.
Differences from
1990 experience
Though the current situation of banks in terms of their appetite for mortgages is similar to that during the recessionary environment back in the early 1990s, there are differences between now and then that are worth taking note of.
According to Lehman's Modukuri, in late 1999 and most of 2000, banks were buying securities primarily through the ABCP conduits while they pretty much stayed away from the securities cash market. This did not really happen during the early 1990s.
"The banks - to the extent that they really wanted to increase their exposure to securities - can still add securities through off-balance-sheet vehicles and not necessarily buy mortgages through CMOs to put them on balance sheet," said Modukuri.
However, in this volatile economic environment, it is difficult to say how much ABCP conduit activity is taking away from the current appetite for mortgages.
Another notable difference is the fact that through consolidation bigger and more sophisticated players in the banking sector have emerged.
These banks are able to hedge out incremental exposure through the use of swaps.
Modukuri said that banks pretty much fund on the front-end so they usually go for short-duration assets such as short sequentials and not long-duration products such as thirty-year mortgages. But if banks have active hedging programs then they could buy a thirty-year pass-through, for example, and hedge out further duration exposure through the use of swaps.
This ability to hedge long-term assets has led to the increase in the amount of pass-throughs being bought by banks today, Modukuri said.
Extension risk and bank demand
In a recent Bear Stearns report, analysts said that bank demand should continue to be strong and would be able to absorb the supply wave. However, analysts from the bank warn that the market is not paying attention to the potential for higher future rates and extension.
They gave the example that on an OAS basis most of the MBS sector appears to be rich versus Agencies, swaps and Treasurys although nominal spreads are still at historically wide levels.
"The relative richness of MBS on an OAS basis is telling us that the market is vulnerable to a market sell-off," said Bear. "Indeed, we would expect the mortgage market to underperform in a sharp sell-off as banks, the backbone of the market today, would likely have to liquidate positions to reduce their MBS duration."
However, other analysts are saying that though bank selling is a possibility in a rate-back-up scenario it is not a huge overhang in the market right now. Banks would be reluctant to sell mortgages in this environment because it would mean that they would have to book losses on their portfolios. In a rate back-up, there would be plenty of ways to take off duration from a bank's balance sheet, and one of which is to enter into a swaps contract.
