With mortgage-to-debt spreads less attractive lately, leading to the virtual disappearance of the GSE arbitrage in the 30-year sector, the GSEs' retained portfolio purchases are expected to remain light in the near term, analysts said.

Historically, the GSEs fund their mortgage purchases in their retained portfolios mainly through their debt. Such operation has traditionally been profitable for GSEs as a result of the attractive spread between mortgages and Agency debentures. However, because of the recent outperformance of mortgages, the sector has richened relative to Agency debentures, causing the spread between the two to tighten significantly.

This has caused Fannie Mae and Freddie Mac to be less active in their purchases of mortgages for their retained portfolios. In fact, in its monthly financial summary, Fannie Mae cited tighter mortgage-to-debt spreads as one of the key reasons that mortgage commitments slowed in March.

In a recent report, Morgan Stanley mortgage strategist Yubo Wang said that in March Fannie's and Freddie's retained portfolio growth slowed significantly to an annualized rate of 2.4% (for Fannie Mae) and 7.4% (for Freddie Mac). Wang said that the two agencies together only added $4.67 billion of securities to their retained portfolios in March, which is much less than the average of $24 billion per month in the preceding three months.

Separately, analysts from JPMorgan - citing the fact that the OAS to the agency curve are lower versus swaps - said that they are anticipating that GSE retained portfolio growth should slow dramatically. They added, "We would not be surprised if there were no growth in the second quarter."

Bye-bye arbitrage

With Agency OAS on mortgage bonds close to, if not slightly tighter than, the Libor OAS on some MBSs, the GSEs would not have the comparative advantage - if they are funding themselves at Libor - to those who are also funding themselves on a Libor basis. The two agencies had been funding themselves at sub-Libor levels, which had allowed them to compete effectively with some money managers who fund themselves against Libor.

However, if they can't issue debt at sub-Libor levels then the arbitrage would obviously go away, said MBS analysts at JP Morgan.

In a publication dated May 4, the firm said that the GSE arbitrage has been virtually eliminated in the 30-year sector with agency benchmarks trading about eight basis points over swaps and the five-year just four basis points through swaps.

GSEs out, banks in?

Aside from the GSEs staying on the sidelines, money-managers are currently very heavily overweighted in MBS, leaving no incentive for them to add further exposure at current levels, noted JPMorgan. With GSEs and money managers - two pillars that traditionally supported the MBS market - currently not very active, will banks, which are considered to be the third pillar, pick up the slack?

JPMorgan is expecting bank activity to remain modest. The firm said that the regional banks are the ones who have been adding MBS to their portfolios, while the larger money-center banks seem to have tapered their growth, despite the dip in their loan holding.

The firm added that though bank activity has gone up modestly in the past few weeks, this increase in purchases came right after actual portfolio contraction in February and is not enough to drive MBS spreads tighter, especially if the market continues to rally.

But other Street firms are a tad more optimistic about banks being aggressive at this juncture.

In a recent report, Lehman Brothers chartered the growth rates of total assets for U.S. Chartered Commercial Banks and found that the decline in bank assets for the first quarter of 2001 was significant. Bank assets went down by 9% in the first quarter, which was the biggest dip in more than a decade.

Lehman stated that the last time bank rates trended down was in the summer of last year. This dip was quickly met with aggressive securities purchases. According to analysts, bank response may not be different this time around because with loan demand still slow, the only way for banks to meet growth rates is through the securities market.

And with the market rallying and rates declining significantly, prepayment risk is once again on the forefront. Though this can be viewed as a negative from the MBS investor's standpoint, banks usually like mortgages with shorter durations. So with agencies now taking the backseat, banks are expected to become the marginal buyer of mortgages.

What's next?

With the GSE arbitrage on the wayside, analysts have different views about what this means going forward. Some said that this may mean that there will be some short-term trading opportunities in buying Agencies vs. MBS.

Morgan Stanley's Wang said that decreasing GSE activity, combined with the increasing amount of mortgages that need to be absorbed by other players, have not impacted the mortgage market negatively, so far. However, he noted that this is something that always has to be closely monitored.

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